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The power of compounding, and how it works in Mutual Funds

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The power of compounding, and how it works in Mutual Funds

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Ever since I started investing, I’ve had parents, elders, and family members advise me against it. Their logic being that it’s extremely risky, and their never-ending stories of how some distant relative went broke after losing their money in the market. 

And frankly, I don’t blame them. They come from a time when they had limited means of learning about its benefits, and the concept of compounding was pretty much alien to them.

But they’re also right when they say that it’s risky. But with a little bit of homework, being self-aware, and taking advantage of your time, the risks can be reduced significantly.

I realised the merit of this bit of wisdom in time. But thankfully, not too late. So, here are my proverbial two cents on the benefits of investing early, the power of compounding interest, and how to make it work for you. 

Compound interest: Where 1+1 = 2.5

Mathematics enthusiasts can speak for hours on the concept of interest and the difference between simple and compound interest. But I do not intend to bore you with too much technicality on this matter. 

The shortest definition of compound interest is interest on your principal investment and the interest generated on it over a period. In other words, when you regularly invest over a period of time at a certain interest rate, you get returns on the original investment. Moreover, as the time period increases, the original amount keeps growing due to the addition of regular interest (also known as reinvestment) to the main corpus. Naturally, the absolute returns received, thus, become significantly higher and continue to do so throughout the investment period.

Making your money work at the speed of compounding

The true power of compounding can be easily understood by using an example. 

Let us presume person X invests ₹1 lakh in a financial instrument that gives an assured return of 10% per annum. For a five-year investment tenor, the calculation for simple interest (or interest on principal) is like this. 

10% of 1,00,000 = ₹10,000 is the interest amount each year. Multiplied by 5, and the absolute returns are ₹50,000, and the final amount is ₹1,50,000 over the course of the investment period.

But what if person X chooses to reinvest the yearly interest amount as well? Reinvesting this interest amount with the initial amount is known as compounding. How would compounding interest make the final return look? Let’s see

Year 1: 10% of 1,00,000 = ₹10,000. Total corpus = ₹1,10,000.

Year 2: 10% of 1,10,000 = ₹11,000. Total corpus = ₹1,21,000.

Year 3: 10% of 1,21,000 = ₹12,100. Total corpus = ₹1,33,100.

Year 4: 10% of 1,33,100 = ₹13,310. Total corpus = ₹1,46,410.

Year 5: 10% of 1,46,410 = ₹14,641. Total corpus = ₹1,61,051.

By simply choosing to reinvest the interest earned, person X has gained an additional ₹11,051 in the same financial tool over the same investment period. Which means a windfall of 11.05% over the traditional approach of investment. This is just a glimpse into how you can make your money work for you by investing wisely. It is easy to imagine how the savings can go up exponentially when invested over longer periods—the same ₹1,00,000 more than double and become nearly ₹2,68,506 if invested for 10 years, and so on. Surely, now it must be clear why investing early can provide fantastic gains.

The interesting case of mutual funds 

Not only starting early, but experts also recommend staying invested for longer periods to truly build a healthy corpus. A quick buck here and there will only get you so far. While there are various types of investment avenues to choose from, personally, mutual funds seem to be the most convenient, simple and effective. 

The convenience and simplicity stem from the fact that the entire process is online and provides a plethora of options. Just a few taps and you can invest a fixed amount as a lump sum or choose to have smaller amounts deducted each month by means of an SIP. 

Furthermore, there are several types of mutual funds to choose from. Choosing the right one requires a proper understanding of your own risk appetite, investment style, and preferred investment period. You can choose to invest in equities, which may come with higher risk and higher returns. Or you can choose to invest in low risk, stable, fixed income security funds as well. There is something out there for everyone.

Mutual funds are genuinely effective in building long term wealth and allow the option of diversification too. Remember the phrase ‘don’t put all your eggs in one basket’? This holds true while investing as well, which is why you can create a balanced corpus using the different types of mutual funds available out there. 

While starting out, you may choose to invest through a broker or a fund house with some minor charges as commission. Once experienced, you have the option of investing in direct funds and can save on the commission, which gets added to your corpus instead. 

Summing it up

Irrespective of the instrument you choose, investing regularly is the key. While starting early is strongly recommended, there is no right time to invest. Or let me put it this way, the right time to invest is -- now! Overthinking or waiting for the ‘perfect’ market conditions is bound to extend your procrastination. Do your groundwork, understand the product you’re investing in, consider the risks, chalk out your goals and the corresponding investment duration, and dive right in.

Frequently Asked Questions

1. Is mutual fund interest compounded monthly?

Mutual funds are not compounded monthly. Interest on mutual funds grows as the fund does. You could invest in a mutual fund and tap into your earnings years later as well. Your interest grows based on the amount you have invested, and the duration you have been investing for.

2. Which fund is best for compound interest?

Here are some of the best options for compound interest -

  1. Index funds
  2. Mutual funds
  3. ETFs
  4. Dividend-paying stocks
  5. Banking bonds

3. Does SIP have compound interest?

SIP relies on the power of compounding, this is the process of reinvesting your investment returns to earn even more returns. By investing a fixed amount of money at regular intervals, you can take advantage of the power of compounding to grow your investments over time with SIPs.

4. Why there is no compounding in mutual funds?

Compounding in mutual funds isn't as straightforward as other investments. When you invest in a mutual fund, you can choose to reinvest your dividends or capital gains automatically. This means that instead of receiving cash payouts, the money is used to purchase additional units of the mutual fund. Over time, this can lead to compounding returns as the additional units purchased with reinvested dividends or capital gains generate their own returns.

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