Power of Compounding
Compounding is nothing but the power of compound interest working its magic on your money. The amount of interest that you earn on your savings keeps getting added back to the principal, and the interest amount is then calculated on the new principal amount. Now, since the principal amount keeps growing every year, so does your return. This is the power of compounding.
Let’s understand it with an example, if you decide to invest Rs. 2,00,000 at a rate of return of 10% today, then at the end of 5 years, your maturity amount will be ~ Rs. 3,22,102. That implies that you have earned Rs 1,22,102 without you putting in any hard work. The only thing at work here is the power of compounding interest. Had the same investment been on the simple interest concept, your earnings at the end of 5 years at the same rate of return, would have been Rs 1,00,000. The compounding effect in the former case is evident.
Mathematically, the formula to calculate the compound interest is as below-
A= P(1+r/n) ^ (nt)
Where A= value of the investment in the future
P= value of the investment in the beginning/ principal amount
r= rate of interest
n= number of times your capital gets compounded in a particular period, say, a year
t= number of such periods, say, number of years for which the money is invested for
However, if you want to see how your investment in a SIP mode of investment in mutual funds, will behave with time; you can check our SIP calculator page; rather than calculating it yourself.
Want to learn more about the modes of investing in mutual funds? Click here.
How does the power of compounding work in mutual funds?
Power of compounding in case of mutual fund investments can be one of the most effective ways of wealth creation. Let’s say you invested Rs 100 and the compound interest had you earn Rs 5 on this investment. Now, in the next compounding cycle, the return will be calculated on Rs 105 instead of Rs 100. Hence, with compounding, there is a possibility of you growing the corpus exponentially rather than linearly.
However, just like you ought to give time to the orchard to grow fully; compounding requires time. Let us understand this with an example:
For retirement planning, A started investing Rs 2000 per month at the age of 30 and on the other hand, B started investing Rs 4000 at the age of 45. Both A & B invested till they were 60. So, in effect, both A & B invested Rs 7,20,000 but for different periods of time and via different SIP amounts. Assuming the rate of return was 10% for both, let us see how much corpus they accumulated.
|Age||For A||For B|
|At 35||Rs 1.6 Lakh|
|At 40||Rs 4.1 Lakh|
|At 45||Rs 8.4 Lakh||0|
|At 50||Rs 15.5 Lakh||Rs 3.1 Lakh|
|At 55||Rs 26.8 Lakh||Rs 8.3 Lakh|
|At 60||Rs 45.58 Lakh||Rs 16.71 Lakh|
*No inflation has been considered for the calculations
**Assumption is that the rate of return is constant, and A & B are investing in the same scheme throughout the respective period
In the above example, despite investing the same amount of money, A’s corpus is almost 2.7 times that of B! What has worked in A’s favour is the investment period, which is double that of B. Please note that in real life, there are factors like inflation, fluctuating rate of return and market forces affecting your actual returns. Hence, your returns will not match the ones shown in the example above. But the longer the investment is for, the more benefit of the compounding effect are you likely to see.
This is because this is how compounding works; which may help returns to grow exponentially with time.
The benefit of compounding in the mutual fund schemes may increase in the below scenarios-
- If you start saving and investing at an early age.
- If you stay invested for a longer period.
- If the compounding interval is shorter. For example, if the compounding happens quarterly instead of annually.
As a mutual fund investor, you can possibly get better returns by investing via the systematic investment plan (SIP) mode of investment.
Power of compounding in SIP
Investment in mutual fund schemes via the SIP mode helps to enjoy the benefit of compounding. SIP is a long-term wealth creation tool that may help to average out your costs and risks; similarly, as we have seen in the above examples, the compounding effect may grow manifold in a long-term investment. So, SIP and Power of Compounding work hand-in-hand.
SIP is about being able to invest in small, pre-defined chunks of money in your chosen mutual fund scheme and in the process, saving you from having to time the market while inculcating a disciplined investing approach in your routine. Depending on the market condition, the number of units of mutual fund schemes bought every month varies in number. Power of compounding adds to this benefit, to make the SIP mode of investment a relatively more stable one, in the long-term. You can allocate a different SIP to each of your financial goals and let the compounding benefit work its magic!
Tips to reap better benefits from the power of compounding
The compounding effect increases with the increase in your investment horizon. Hence, for the same goal, if you start investing earlier, you are more likely to reap relatively better benefits. For example, you can always start saving for your retirement as you start earning rather than waiting until you are in the age range 35-40. Because of the power of compounding, you may end up with a relatively much greater corpus at the actual time of retirement.
Stay invested/Think before cancelling SIP-
As much as possible, you ideally should not redeem your mutual fund investments unless you have reached your life goal for which you had started investing. Also, each time you invest afresh, you lose out on the compounding benefit that you had derived till then.
Increment on investments-
If you are investing a fixed amount via SIP, it may be a good idea to increase your SIP outgo as the years go by as there is an increase in your monthly income. The power of compounding will play its part on your investment even if you do not top-up your SIP, but with periodic increments in your SIP, the compounding benefit can also considerably increase.
For the power of compounding to work its magic into your investment, it is imperative that you begin your mutual fund investments via SIP today! Click here to know how a SIP investment works.
Want your investments to benefit from compounding? Begin here!