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How the Power of Compounding in Mutual Funds Makes You Rich Research Team | Posted On Friday, January 24,2020, 05:34 PM

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How the Power of Compounding in Mutual Funds Makes You Rich



We often hear about people making exceptional retunes through mutual fund investments. It makes many investors doubt such investments as they seem too good to be true. However, when we search the market, we find the best schemes to invest are mutual funds.

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How the Power of Compounding in Mutual Funds Makes You Rich

Is a mutual fund investment capable of generating good returns? How does this scheme work?

Let’s try to understand the basic factors that help mutual fund investment to grow and how it works to give exceptional returns.

The Two Pillars of Growth:

Any investment cannot give you returns overnight. For your investments to grow you must be patient and give ample time to it. The more time an investment gets the more it grows. Many investors fail to gain good returns on their investments either because they do not hold it for the required time horizon or because they invest in something that does not have the potential to generate good returns.

All of us know the power of compounding. Compounding is not a simple mathematical formula that we learnt in our textbooks. It is a powerful tool that can boost our returns on investment. Thus each time your investment compound your principal becomes bigger and as a result, your investment fetches interest based on the new principal.

See Also: The Power of Compounding

Therefore, the point here to note is that as your principal amount grows so does the amount of interest you receive even if the interest rate remains constant throughout the investment tenure. This is the reason why a financial expert advises you to opt for longer investment tenure. In case of mutual fund investment, the interest and dividend payments get reinvested thus increasing your maturity payout.

Compounding in the Case of Mutual Funds:

 In case of investments like mutual funds, you do not earn an interest amount, unlike FDs or RDs. What actually happens is that the number of units you buy grows in number. The income in mutual funds mainly comes due to rupee cost averaging as the value of your funds goes up over time. Thus in case of mutual funds, the returns is generated in the form of capital gains which is reinvested to create additional gains.

For example, if you have invested Rs. 10,000 in mutual funds. In returns, you are able to buy 100 units if mutual fund and each unit cost you Rs, 100. The price of every unit of mutual funds is known as its NAV. Now let’s assume that after sometime that NV of the funds goes up and becomes Rs. 110. Here the growth of the amount from 100 to 110 means you have made capital gains. Thus your capital gains are Rs. 10 per unit.

See Also: How Mutual Fund SIPs Benefit from Power of Compounding

Your investment now stands at Rs. 110*100 = Rs. 11,000. Thus over the tenure, your investment have grown by Rs. 1000. This is how you experience gains in mutual funds. Now, if you keep investing the same amount at regular intervals, then you investments would not only grow due to the new investments but your initial investment will fetch the best returns. Thus the older your investment gets the more returns you can get. This is because you have devoted enough time for it to compound and grow.

Thus this effect of compounding can be compared to the compounding of interest where the principle grows every year.

See Also: Understand the Power of Compounding and Advantages of Investing in SIPs

Now suppose you have invested for a period of 10 years, then your initial investment of Rs. 10,000 would grow the most as it has got 10 years' time to grow. If you compare this with the last installment that you made, it will have only 1 year to grow. Thus it will grow the lowest. This is compounding in action.

What You Should Take Away From All This:

Though compounding is simple, it is a powerful concept. 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.

Now that you already have an idea of how mutual funds work, you can make better investment decisions. The longer you remain invested, the time you give your investment to grow. So these are ideal investment options for investor who can devote ample time to their investments. The earlier you start, the more growth your investments will see.

See Also: How Compounding Can Make You Rich?

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