The most notable aspect of compounding is that it allows you to generate an extra income along with the previous earning and base investment. For example, if you have invested a sum of Rs. 1 lakh as the principal amount that compounds at 10% per annum for a tenure of 15 years, then you will have created a maturity amount of 17,725. This is how compounding helps your money grow over time by creating a cycle of earning.
While investing money, you must keep in mind the importance of compounding in growing your wealth. To keep your wealth growing you must not withdraw the returns. If you withdraw money it will not help you grow your base investment.
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Though compounding is simple, it is a powerful concept as the interest earned on investment also earns an interest. The mutual funds are designed in a way that they carry the power of compounding. You will be able to gain more money as your basic investment goes up due to compounding. When you make investments for a long time, compounding helps you benefit by adding your initial investment, returns on investment plus your consequent investments to generate a greater return. This cycle goes on until the fund matures.
In mutual funds, the income generated is known as capital gains which are reinvested to create additional income. Compounding in mutual funds has a multiplier effect as the interest earned by the initial capital also earns interest.
See Also: How Mutual Funds Work?
For example, if you invest Rs 1,000 every month in a mutual fund for a tenure of 10 years at a rate of 8% per annum. You will receive a higher maturity amount on your investments due to compounding. Your investment of Rs 1,20,000 gave you a return of Rs 1,82,946 during maturity. Now, if you opt to re-invest the maturity amount for another ten years, then money reinvested will grow even faster this time and will fetch you a maturity amount of Rs 3,94,967. This is the magic of compounding. Your existing investment along with the returns on this investment and the new investment at regular intervals will add up to contribute towards further gains.
If there was no compounding then your investments would grow in a linear manner and there would be only interest income over the investment tenure.
Start Early: the best way to benefit from compounding is to start saving as early as possible. The earlier you start the better it is. If you start investing in mutual funds from the time you enter the professional world, it will help you make a corpus as your funds amplify over time.
Financial Discipline: to create a good investment portfolio you must outline your priorities and keep investing regularly. Once you inculcate the habit of disciplined savings you will be able to save money regularly. To get financial discipline you must know your necessities. You must also understand that being a disciplined investor will help you achieve your financial goals faster. Patience: you must consider a long-term strategy to get good returns by investing a minimal amount. Instruments that give quick returns over a short term are too risky and need investments in higher denominations. A long-term mutual fund investment will reap you better benefits without the risk and by compounding your investments. By being patient you can allow your investments to grow slowly and steadily over the years. This type of dedicated investment will give a robust corpus during maturity.
Check Your Spends: to save efficiently you must know where you should spend your money. To efficiently save money you must write down an expenditure plan and stick to it. This is known as budgeting. It ensures you pay for only what is necessary thus helping you to cut down other unnecessary expenses.
As an investor, you must first determine your financial goals and the amount you can save regularly from your monthly income. You must consider various factors like your financial liabilities, EMI payments and necessary expenses to understand how much you can invest each month.
There are several online calculators online that will help you to evaluate the amount you need to invest over tenure to reach your financial goals. These online calculators will give you an idea about how much time is needed for compounding your money, the prevailing rate of interest and the investment amount needed each month.
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