Investing in mutual funds has off-late gained a lot of attention. Although this mode of investing has been existing in the market for quite some time, the vast benefits have been lately realized. Several phenomena and formulas work behind the inflation-beating returns of mutual fund investments.
One such phenomenon is the power of compounding. Although this magical potion has been secretly tapped by seasoned investors, the common investor is still exploring the horizons.
As many well-renowned names have quoted, compounding is one of the strongest forces that exist. Albert Einstein also realized the power of this concept and said, "Compound interest is the strongest force in the world. If you fail to understand it, you will have to pay it and if you do, you earn it."
However, mutual fund investments are not a day's game. It takes a lot of conviction and diligence to earn the desired profits. The power of compounding works on the idea of wealth appreciation and requires a decent time-frame to work on your money. This is no magic but simple mathematics that allows your money to multiply and create wealth over the investment horizon.
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Here is how the power of compounding works:
Let us begin with understanding the SIP concept where compounding takes place:
SIP stands for a systematic investment plan which is a way of investment that allows investors to invest in mutual funds, systematically. SIP allows investors make periodic regular investments of pre-determined amounts at pre-fixed time intervals like savings and investments are automated.
See Also: The Power of Compounding
When you opt for SIP, your bank account is linked and the deductions are made in an automatic manner. The investors can opt for weekly, monthly, quarterly and bi-annually SIPs as per their choice. SIP has revolutionized the way people saw mutual fund investments. Traditionally only investors with a lump sum amount could think of investing in mutual funds but with the introduction of SIP, small investors are also welcome.
SIP is powered by two investment market concepts:
Here are some insights into the Power of Compounding;
Compounding is the term used for compound interest. The profits that are earned over the investment horizon are compounded each year back into the principal investment and a new investment starts after every period. Simply put, the longer you stay invested in the mutual funds through SIPs, the higher are the returns.
For instance, two colleagues Kunal and Mrinal who are 23 and 30 years old respectively start investing in mutual funds. They have started with a SIP of Rs 5,000 a month at an interest rate of 8.5%. Now, by the time both of them retire at 60, Kunal would have reaped exponentially greater benefits as compared to Mrinal due to a longer investment horizon.
Under the compound interest calculation, the interest you earn on your principal investment is compounded back or added back to the primary investment and re-invested as a new principal amount.
Let us understand this with an example. You invest Rs 100 in mutual funds through SIP and earn Rs 20 on it in the first year. Hence for the first year, your principal amount is Rs 100 and interest earned is Rs 20.
Now, in the second year, your earned interest will be added to the initial investment, so for the second year, your principal amount will be Rs (100+20) = Rs 120 and the newer profits will be earned on this principal investment.
Assuming you again earn profits at the rate of 20%, your interest earned for the second year will be 20% of 120 which is Rs 24. So for the third year, your principal investment will be Rs (120+24) = Rs 144.
The power of compounding is best realized when investments are made for a longer investment horizon. In a nutshell, sooner the better as more you stay invested; the higher will be your earnings due to the compounding effect.
Here are a few things to practice to reap the best benefits:
The first thing to do is to start early. Now is the right time to start investing in mutual funds through SIPs. The longer the investment horizon, the greater are the profits.
You must be regular with your investments. Spending money is easier but taking a chunk out of your income and setting it aside for future use requires discipline.
When you invest for a longer time horizon, it is always better to invest in high return instruments. The risk gets hedged over the long period and reaps exponential benefits.
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