Do you want your money to work for you and grow rapidly? Whether you want to build your wealth slowly or quickly, there is a secret to getting higher returns from your investment. Warren Buffet has said, “My wealth has come from a combination of living in America, some lucky genes, and compound interest.”
Continue to read this blog to understand how compounding works in mutual funds and how it can be leveraged to build wealth consistently.
What is Compounding?
In your investment journey, understanding compounding is crucial. It is a simple financial concept that increases returns multifold over the long term. Compounding refers to reinvesting interest or returns from investment. When you gain returns from an initial investment, allow it to grow exponentially over a long period by reinvesting it. So, you receive returns not just from the initial investment but also from the interest accumulated.
You can unlock the power of compounding in mutual funds by continuing to reinvest in the market. It is the best way to build a corpus, focusing on long-term growth. As you continue to invest your returns, your investment sum grows, resulting in higher returns. Just by staying invested, you can enjoy constant wealth enhancement.
By staying committed to your investment approach, you can reach your financial goals quickly and easily using the power of compounding. To benefit from compounding in mutual funds, you can make a lumpsum investment or choose Systematic Investment Plans (SIPs).
The mathematical formula to compute compound interest is:
A =P(1+rn)nt
Where A = total corpus in the future
P = principal amount invested
r = rate of interest
n = number of times the investment is compounded in a period (for example, how many times the amount is compounded in a year)
t = number of periods (for example, the number of years for which you keep the money invested)
How Compounding Works?
When 1+1 equals 2, the compounding principle can make it 2.5! Let’s understand this with an example.
Suppose you invested Rs. 1,00,000 with a return rate of 10%. So, your investment will generate Rs. 10,000 interest at the end of every year. You wish to keep the investment active for 5 years. Now, you can withdraw your interest at the end of every year. So, you can withdraw Rs. 10,000 every year. If you do that, your Rs. 1,00,000 investment would have grown to Rs. 1,50,000, and your total return in 5 years would be Rs. 50,000.
Now, consider that you choose the way of compounding. So, instead of withdrawing Rs. 10,000, you continue to invest in the same investment vehicle. This means your investment corpus is increased yearly by Rs. 10,000, and you don’t pay that out of your pocket. This table shows how your returns get compounded:
| Year | Corpus | 10% of corpus | Total Corpus at the End of the Year |
| 1st year | 1,00,000 | 10,000 | 1,10,000 |
| 2nd year | 1,10,000 | 11,000 | 1, 21,000 |
| 3rd year | 1,21,000 | 12,100 | 1,33,100 |
| 4th year | 1,33,100 | 13,310 | 1,46,410 |
| 5th year | 1,46,410 | 14,641 | 1,61,501 |
So, with compounding, your Rs. 1 lakh investment would have grown to Rs. 1,61,501, earning you returns of Rs. 61,501. Without compounding, your returns would be Rs. 11,501 less.
Compounding can work wonders if you keep investing for an extended period. For example, the same Rs. 1 lakh will compound to grow to Rs. 2,68,506 if you keep reinvesting your returns without investing anything extra.
How Compounding Works with Mutual Funds?
With mutual funds, reinvesting the returns and staying invested long-term helps you leverage compounding. When your mutual funds invest in dividend-generating stocks, the companies will declare dividends from time to time. As an investor, you will receive dividends based on the number of units of mutual funds you hold.
If you choose a dividend reinvestment plan, you can reinvest the dividend into the same mutual fund. As a result, the number of mutual fund units you hold will increase. If you continue to do this for a period of time, you will end up with more mutual fund units than you initially invested. This will result in higher returns.
With equity mutual funds, you can reinvest the returns from the stocks to benefit from compounding.
Tips to Improve Compounding Benefits
Whether you invest as a lump sum or as a SIP, you can get the benefits of compounding. Maximising the power of compounding simply by continuing to invest is possible. Here are some tips that will help you expand compounding advantages:
- Start investing early – Even if you can afford to invest just Rs. 5000 per month, you will build a substantial corpus when you start investing early. For example, to build a retirement corpus of around Rs. 3 crore, a person beginning to invest at Rs. 25 must invest only Rs. 5000 in SIP with a modest return of 12%. However, if the same person only starts to invest at Rs. 45, he has to invest at least Rs. 64,500 per month to achieve the same corpus by the time they reach 60 years.
- Stay invested – Redeeming mutual funds before you reach your goal will result in losing the power of compounding. Stop yourself from cancelling SIP because even though you may have a tight budget now, your corpus can grow substantially in a few years by compounding.
- Increase your investments – Continuously investing a fixed amount via SIP will help you grow your money. However, as the years roll through, your income will increase. Consider increasing your investment, such as top-up SIM, to help your money grow faster.
Conclusion
Invest as soon as you start earning to harness the power of compounding. Regardless of how much money you invest in a month, even a small sum can pave the way for financial freedom. Reinvesting your returns and selecting suitable mutual funds can help you accumulate long-term wealth. Also, a disciplined approach to investing in the form of SIPs will keep you away from impulsive decisions based on market conditions.
FAQs
No, mutual fund interest rates are not compounded monthly. The rate of returns for a year varies based on the fund’s performance. Reinvesting your returns will help with compounding by increasing your investment without using out-of-pocket cash.
Different types of mutual funds support compounding. Before investing, read your documents and check the reinvestment plan.
With lumpsum investment, you invest once and reinvest returns consistently. SIPs are more suitable to benefit from compounding as you can use market conditions to increase the compounding effect.
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Disclaimer: Investments in the securities market are subject to market risks; read all the related documents carefully before investing.