Skip to Main Content

3 Pillars of Compounding: Investment Amount, Investment Time Horizon, and Rate of Return

Looking to understand the power of compounding in mutual funds? Read this article to know about the three important pillars of compounding in mutual funds and its benefits.
power-of-compounding-glide-invest

We have all heard Albert Einstein's famous quote: "Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn't pays it."

Compounding has three pillars:

  1. Investment amount
  2. Investment time horizon,
  3. Expected rate of return.

This article will understand how each of these pillars influences the compounding process.

So, let us start with the first pillar of compounding: investment amount.

Investment Amount

The investment amount directly impacts the amount you will accumulate at the end of the investment period. Other things being constant, the higher the amount you invest, the higher the corpus you will accumulate.

A systematic investment plan (SIP) is a good way to invest a fixed amount regularly every month. You can also use a step-up SIP to increase the investment amount every year as your salary increases. Using a step-up SIP, you can increase the annual investment with a specified amount or percentage.

Let us understand how the investment amount impacts the corpus you accumulate with an example.

Siddharth, Prachi, and Ritika start a SIP at the age of 25 years. They plan to continue investing in the same equity mutual fund for the next 35 years till their retirement. The fund is expected to give a 12% CAGR. Siddharth starts her SIP with Rs. 2,000 a month, Prachi starts with Rs. 3,000 a month, and Ritika starts with Rs. 4,000 a month. Let us see how much will each of them accumulate on retirement.

InvestorAnnual investmentInvestment time horizonExpected rate of returnRetirement corpus
SiddharthRs. 24,00035 years12% CAGRRs. 1,16,03,114
PrachiRs. 36,00035 years12% CAGRRs. 1,74,04,672
RitikaRs. 48,00035 years12% CAGRRs. 2,32,06,229

The above table shows that Ritika's retirement corpus will be double of Siddharth's retirement corpus as Ritika's investment amount is double that of Siddharth's investment amount. So, the retirement corpus will be directly proportional to the amount you invest. Hence, if you wish to accumulate a bigger corpus, make sure your investment amount is appropriate, other things being constant.

If you cannot start your SIP with the requisite amount, you can start with whatever amount is available. Over time, you can increase the investment amount every year as your annual income increases.

Investment Time Horizon

The investment time horizon is the second pillar of compounding. The compounding process needs time to show results and create wealth for you. Hence, financial advisors recommend that you start investing towards your financial goals the moment you start earning. Also, if you start investing early, you will have to invest a lower amount in accumulating the same corpus than someone who starts investing later.

Let us understand how the investment time horizon impacts the retirement corpus you will accumulate with an example.

Siddharth, Prachi, and Ritika start a SIP for accumulating their retirement corpus. All three of them are investing Rs. 10,000 a month. They are investing in the same equity mutual fund (expected to give a return of 12% CAGR) and will continue investing till the retirement age of 60 years. However, Siddharth starts her SIP at age 25, Prachi starts at age 35, and Ritika starts at age 45. Let us see how much will each of them accumulate on retirement.

InvestorAnnual investmentInvestment time horizonExpected rate of returnRetirement corpus
SiddharthRs. 1,20,00035 years12% CAGRRs. 5,80,15,573
PrachiRs. 1,20,00025 years12% CAGRRs. 1,79,20,072
RitikaRs. 1,20,00015 years12% CAGRRs. 50,10,393

The above table shows how Siddharth will accumulate a huge retirement corpus of Rs. 5.80 crores because she started investing early, as soon as she started earning. Ritika will end up accumulating only Rs. 50 lakhs because she started investing 20 years later than Siddharth. Ritika's retirement corpus is less than 10th of Siddharth's retirement corpus.

The above chart shows how Prachi will reap the benefits of compounding as she starts investing early. The more the delay in starting your investments, the lower the amount you will accumulate. Hence, to benefit from the magic of compounding, you should start investing early for your long-term financial goals, such as building a fund for a child's higher education or your own retirement.

The impact of investment time horizon on compounding is similar to planting a bamboo tree or a mango tree. A bamboo tree does nothing for the first few years. But, once it starts growing, it reaches a substantial height in a few months. Similarly, a mango tree doesn’t yield any fruits for the first few years. But, once it starts, it gives you a lot of mangoes every season.

In the case of compounding also, you will not see much change in your accumulated corpus in the first few years. But, you still need to continue your SIP investments regularly in a disciplined manner. Only after 5-7 years of continued monthly investments will you start seeing a meaningful compounding impact on your accumulated corpus.

Expected Rate of Return

The expected rate of return is the third pillar of compounding. The expected rate of return will depend on your choice of investment products. The choice of investment products will, in turn, depend on your risk profile.

The risk profile of an investor can be categorised into three types:

  1. Aggressive risk profile: An investor with an aggressive risk profile has a higher capacity to invest in riskier financial products such as equity mutual funds. While equity mutual funds carry high risk, they have the potential to give inflation-beating high returns in the long run.
  2. Moderate risk profile: An investor with a moderate risk profile takes a balanced approach between equity and debt financial products. Such an asset allocation carries a lower risk than an equity portfolio, and the return potential is moderate.
  3. Conservative risk profile: An investor with a conservative risk profile has a low or no appetite to invest in riskier financial products such as equity mutual funds. The investment portfolio mostly consists of fixed-income products. Such a portfolio has the potential to deliver moderate to low returns.

Let us now understand the impact of the rate of return on your retirement corpus. Siddharth, Prachi, and Ritika start a SIP at the age of 25 years for accumulating their retirement corpus. All three of them are investing Rs. 10,000 a month, and plan to continue investing for the next 35 years till their retirement.

The risk profile of the three investors is as follows:

Siddharth has an aggressive risk profile and is investing in an equity mutual fund. She is expecting a 12% CAGR on her investments.
Prachi has a moderate risk profile and is investing in a balanced mutual fund. She is expecting a 10% CAGR on her investments.
Ritika has a conservative risk profile and is investing in a debt mutual fund. She is expecting an 8% CAGR on her investments.

Let us see how much will each of them accumulate on retirement.

InvestorAnnual investmentInvestment time horizonExpected rate of returnRetirement corpus
SiddharthRs. 1,20,00035 years12% CAGRRs. 5,80,15,573
PrachiRs. 1,20,00035 years10% CAGRRs. 3,57,75,216
RitikaRs. 1,20,00035 years8% CAGRRs. 2,23,32,257

We can make the following inferences from the above table:

  1. Siddharth will accumulate a huge retirement corpus of 5.80 crores because she has an aggressive risk profile, and is investing in equity mutual funds with an expected rate of return of 12% CAGR.
  2. Prachi is also investing the same amount for the same tenure of 35 years. But, she has a moderate risk profile and is investing in a balanced mutual fund with an expected rate of return of 10% CAGR. Hence, the retirement corpus will be Rs. 3.57 crores.
  3. Ritika has a conservative risk profile. She is investing in a fixed-income mutual fund with an expected rate of return of 8% CAGR. Hence, the retirement corpus will be Rs. 2.23 crores which are less than half of Siddharth's retirement corpus.

The above chart shows how equities can give inflation-beating high returns in the long run. The expected rate of return can make a big difference in the accumulated corpus.

The Investment Time Horizon Has a Bigger Impact than the Investment Amount and Rate of Return

In this article, we have seen how the three pillars of compounding (investment time horizon, investment amount, and rate of return) impact the final accumulated corpus. However, if you have to pick one pillar with the maximum impact, it is the investment time horizon. If you have a long investment time horizon, compounding can help you accumulate a big corpus even if you invest a small amount regularly. Also, a long investment time horizon reduces the risk and enhances the return on investment over time. Hence, you should start investing as soon as you start earning and benefit from the magic of compounding.

Investing in Mutual Funds with the Glide Invest App

In the above section, we understood how the three pillars of compounding can work in tandem and create wealth for you. You can partner with the Glide Invest App for your financial planning journey to get recommendations for the appropriate mutual fund schemes based on your risk profile. You will get advice on planning and systematically investing towards your financial goals.

With Glide Invest, you will get guidance for:

  • A personalized risk profile assessment
  • Identifying your financial goals
  • Appropriate asset allocation
  • Making a financial plan for each goal
  • Automating the financial plan
  • Review and analysis of your financial plan
  • Hand holding you till your financial goals are achieved

To start investing towards your financial goals, download the Glide Invest App Now and Get Started.

Click to start searching
Recent Posts
Focused funds: Should you invest in them?
5 minsOctober 04, 2022
Multi-asset allocation mutual funds: Should you invest in one scheme instead of three?
7 minsSeptember 30, 2022
Rich Dad’s Cashflow Quadrant Book Review
11 minsSeptember 27, 2022
Money frauds Online: More and More People keep falling Prey
6 minsSeptember 23, 2022
World Rowing Championship 2022: Different Investing Lessons the Sport Offers
7 minsSeptember 20, 2022
Posts by Categories
International Investing (3)
Glide Portfolio (3)
Tech (3)
Passive Investing (7)
Goal Planning (9)
Investment basics (10)
All Stash! (10)

Like What You See? Want to learn the simple ways to make investment stress-free?

Sign up for our newsletter & get the best expert advice & news around the financial world

We won’t annoy you more than once a week, Pinky Promise!

Focused funds: Should you invest in them?

Trying to understand focused funds & invest in it? Here is all you need to know about focused mutual funds, its definition, taxation, returns & who should you invest in it

Multi-asset allocation mutual funds: Should you invest in one scheme instead of three?

Learn about multi-asset mutual funds and where to invest them? Learn more about multi-asset mutual funds, benefits, limitation & performance.

Rich Dad’s Cashflow Quadrant Book Review

The Cashflow Quadrant book by Rich Dad provides all the information needed to achieve financial freedom and achieve your income goals.