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Power of Compounding in Mutual Funds: Mutual Fund Compounding Benefits

The general rule is higher the compounding growth rate, the higher will be the final corpus, other things being the same.
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Concept of compounding

Albert Einstein said: “Compound interest is the eighth wonder of the world. Those who understand it, earn it, those who don’t, pay it”. In this article, we will understand the concept of compounding and how it works in investing. Once you understand compounding, you will earn it rather than paying it. Compounding is the process in which the earnings from an asset are reinvested continuously to generate more earnings over a period of time. If you invest in an asset that pays simple interest, your earnings will grow linearly. But, when you invest in an asset that pays compound interest, your earnings will grow exponentially. This is where compounding stands out and every investor should aim for it.

What is Compounding?

Compound interest, also known as compounding, refers to the fact that you receive interest not only on the principal amount you invested but also on the interest that is continually added. It essentially entails reinvesting the profits from your initial investment rather than spending them elsewhere. For example, if you invest Rs 100 per year at 8% interest, your investment would be Rs 100, and your earnings will be Rs 8 at the end of the year (8 per cent of Rs 100). If you choose to reinvest it instead of spending it, your primary amount for the next year becomes Rs 108 (Rs 100 + Rs 8), and your earnings are Rs 8.64 (8 per cent of Rs 108), which is Rs 0.64 greater than the previous year.

Even while this appears to be a modest sum, if you let compounding work its magic over time, it can make a significant difference in your investments.

Power of compounding

The exponential growth that compounding can give can be best understood by looking at the rise in the Sensex levels in the last 30 years. In 1990, the Sensex touched 1000 for the first time. In 2021, the Sensex crossed the level of 50,000. If an investor would have invested in Sensex companies in 1990 and continued with the investment till today, then his/her investment would have grown a whopping 50 times in 30 years.

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How compounding works in investing

Now that we understand the power of compounding, let us look at how compounding works. Let us start with the compounding formula.

compound-interest-formula-glide-invest

Where:

P is the amount invested

r is the growth rate

n is the investment time horizon

t is the number of time periods elapsed

A is the final amount

Let us look at some of these compounding parameters and how they influence your investments.

Amount invested

The lumpsum or systematic investment plan (SIP) amount that you start with has a direct bearing on the amount that you will end up with. Let us assume that there are 5 persons: A, B, C, D, and E who start a monthly SIP in the same mutual fund scheme with an investment of Rs. 2,000, Rs. 3,000, Rs. 4,000, Rs. 5,000, and Rs. 6,000. All of them continue their SIP for 30 years. The mutual fund scheme delivers a compounded annual growth rate (CAGR) of 12%. Let us see what is the amount each of them will have after 30 years.

InvestorAnnual SIP amountCAGRInvestment time horizonFinal corpus
ARs. 24,00012%30 yearsRs. 64,87,023
BRs. 36,00012%30 yearsRs. 97,30,534
CRs. 48,00012%30 yearsRs. 1,29,74,045
DRs. 60,00012%30 yearsRs. 1,62,17,556
ERs. 72,00012%30 yearsRs. 1,94,61,068

As you can see from the above table, the difference between the investment amount of A (Rs. 2,000) and E (Rs. 6,000) is just Rs. 4,000 per month, but the difference in the final corpus is Rs. 1.29 crores, which is huge. So if you want to accumulate a specified amount at the end of the investment tenure, make sure you start with the appropriate amount depending on your investment time horizon and the expected rate of return.

Compounding growth rate

The growth rate at which your investment will compound will impact the final corpus that you will have at the end of the investment time horizon. The general rule is higher the compounding growth rate, the higher will be the final corpus, other things being the same. Let us assume that there are 5 persons: A, B, C, D, and E who start a monthly SIP of Rs. 2,000 in 5 different schemes that give a return of 10%, 11%, 12%, 13%, and 14% at the end of 30 years. Let us see what is the amount each of them will have after 30 years.

InvestorAnnual SIP amountCAGRInvestment time horizonFinal corpus
ARs. 24,00010%30 yearsRs. 43,42,642
BRs. 24,00011%30 yearsRs. 53,01,916
CRs. 24,00012%30 yearsRs. 64,87,023
DRs. 24,00013%30 yearsRs. 79,51,563
ERs. 24,00014%30 yearsRs. 97,61,688

As you can see from the above table, the difference between the compounding growth rate of A (10%) and E (14%) is 4%, but the difference in the final corpus is Rs. 54.19 lakhs, which is more than the final corpus accumulated by A. So, depending on your risk profile and asset allocation, make sure you make appropriate investments in equity mutual funds. They have the potential to give inflation-beating high returns that can help you achieve your financial goals at a faster rate as compared to debt products.

Investment time horizon

Compounding needs time to bear fruit. The general rule is, the more time you stay invested, the better the returns that you can expect, other things being the same. Let us assume that there are 5 persons: A, B, C, D, and E make a lumpsum investment of Rs. 50,000 in a fixed income product that gives a return of 7% CAGR. The investment time horizon of A, B, C, D, and E, is 30 years, 25 years, 20 years, 15 years, and 10 years. Let us see what is the amount each of them will have on maturity.

InvestorAnnual SIP amountCAGRInvestment time horizonFinal corpus
ARs. 50,0007%30 yearsRs. 3,80,613
BRs. 50,0007%25 yearsRs. 2,71,372
CRs. 50,0007%20 yearsRs. 1,93,484
DRs. 50,0007%15 yearsRs. 1,37,952
ERs. 50,0007%10 yearsRs. 98,358

As you can see from the above table, the difference in the investment time horizon of A (30 years) and E (10 years) is 20 years. Due to this, the difference in the final corpus between A and E is Rs. 2.82 lakhs. The corpus accumulated by A is almost 4 times the corpus accumulated by E due to the difference in the investment time horizon of 20 years. Hence, you should give your investment a long time horizon to reap the benefits of compounding.

Frequency of compounding

The general rule is higher the frequency of compounding, the higher will be the final corpus. The frequency of compounding can be daily, monthly, quarterly, half-yearly, yearly, etc. The interest paid by banks on fixed deposits is compounded quarterly. The interest rate on National Savings Certificates is compounded yearly. Earlier the interest rate on NSCs was compounded on a half-yearly basis. The interest rate on Public Provident Fund is compounded yearly. For calculating returns from equities and mutual funds, we consider annual compounding.

Key Rules to Enable Power of Compounding

Power of Compounding has the power of giving higher returns in comparison to simple interest returns. To make the most of the power of compounding, the following key rules can be a boon.

Keep an eye on your spending

Whether you invest Rs. 100 or Rs. 10,000, the compounding principle is the same. However, if you invest a large sum of money, the amount of interest you get can skyrocket.

The most effective approach to take advantage of compounding is to increase your investments. If you have a limited income, though, you can improve your savings by reducing your outgoings. Making a budget and identifying areas where you can cut spending each month is one approach to achieve it. Spending sensibly and intelligently can help you save more money and invest more. You'll have a better chance of getting better results this way.

Begin early

Nothing beats getting a head start on your investments. Ideally, you should begin investing as soon as you start earning money. If you've already passed that point, the next best thing is to begin investing right now. Find a mutual fund that aligns with your financial objectives and begin investing. With the help of compounding, you may build a firm foundation for your finances to grow and flourish in the future if you start investing early. You can use an internet calculator if you don't know how to calculate the return on investment. There are a plethora of calculators online that will tell you precisely how much you need to start investing today to achieve your long-term objectives.

Be Disciplined

It is vital to have investment discipline to build a healthy corpus and reach your financial goals on time. Regular investing at the outset of your investment journey can help you maintain discipline. In addition, it’s a good idea to keep up with your SIP payments. When you invest monthly, you grow your funds and build investment discipline. If you want to be financially successful, this is a must-have habit.

Be Patient

The majority of investors are looking for immediate profits. However, in their haste to generate rapid cash, they may make blunders that result in significant losses. Compounding's power grows stronger over time, as we've seen. As a result, taking a long-term strategy to invest in can be beneficial. It is necessary to invest patiently to gain healthy profits over time.

Becoming a crorepati with the power of compounding

Many people aspire to become a crorepati. When asked about the retirement fund that they would like to have, they are quick to respond with the magic number of Rs. 1 crore. The power of compounding can help you attain the financial goal of becoming a crorepati, depending on the investment time horizon and the expected rate of return. The below table shows the annual amount that you need to invest to become a crorepati depending on the investment time horizon (10 to 30 years) and the expected rate of return (10% to 14%).

Time horizon / Expected rate of return10%11%12%13%14%
30 years₹ 55,266₹ 45,267₹ 36,997₹ 30,183₹ 24,586
25 years₹ 92,437₹ 78,741₹ 66,964₹ 56,867₹ 48,232
20 years₹ 1,58,724₹ 1,40,321₹ 1,23,918₹ 1,09,326₹ 96,368
15 years₹ 2,86,125₹ 2,61,849₹ 2,39,502₹ 2,18,954₹ 2,00,079
10 years₹ 5,70,413₹ 5,38,752₹ 5,08,787₹ 4,80,439₹ 4,53,628

If you invest for a long period (30 years) and if your investment compounds at the rate of 14% per annum, then you can become a crorepati with an annual investment of just Rs. 24,586 (monthly investment of just Rs. 2049). However, if you delay investments, as your age goes up, your risk appetite will go down and you will have to lower your expected rate of return. In such a scenario, if you invest for 10 years and if your investment compounds at the rate of 10% per annum, then to become a crorepati, you will have to invest Rs. 4,53,628 annually or Rs. 37,802 every month. So, to reap the benefits of compounding start investing early in your career, preferably the moment you start earning.

Compounding is all about delayed gratification rather than instant gratification

A lot of people go for instant gratification by spending most of their disposable income on wants and needs. This leaves them with very little or no income for savings and investments. However, compounding is all about delayed gratification. If you can postpone some of your needs and invest that money in mutual funds through SIP mode, you can start your financial planning journey towards accomplishing your financial goals. Compounding requires you to be disciplined with your regular investments. Compounding also requires you to be patient so that your investments can get enough time to grow exponentially over a period of time.

The Takeaway

Compounding works in such a manner that the more you invest when you're young, the more your money will work for you over time and the sooner you'll reach financial independence. As a result, if you want to invest properly, you should take advantage of compounding and start saving and investing early.

Now that you understand the power of compounding, to benefit from it, download the Glide Invest App now and start investing for your financial goals.

FAQs

Q1: What does it mean to compound money?

A1: Compounding is the process of reinvesting earnings from an asset, such as capital gains - interest, to generate more earnings over time. This growth is frequently calculated using exponential functions, and it includes earnings from investments and earnings from past periods. This means compounding is not the same as linear growth, which simply earns interest on the principal.

Q2: How do you make use of the power of compounding?

A2: The most excellent strategy to take advantage of compounding's potential is to begin saving and investing as soon as feasible. The greater the impact of compounding, the sooner you begin investing.

Q3: Where does compounding's power come into play?

A3:  When an individual invests for a longer length of time in mutual funds, the power of compounding is maximised. When the value of fund units rises, investors benefit. It is carried out in mutual funds when capital gains are reinvested to generate new profits.

Q4: What is the benefit of compounding for investors?

A4: The value of time is one of the most important advantages that investors may gain from compounding. You could earn returns over time, and the yields on these returns could generate more returns, allowing you to quickly expand your investments.

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