Understand the Power of Compounding and Advantages of Investing in SIPs

Before we proceed to understand advantages of investing in mutual funds through SIPs, let’s first understand what mutual funds are.

Mutual funds are a pooled investment from various investors. These funds are professionally managed by fund managers. Mutual fund investors can be retail or institutional. The most important benefit of investing in mutual funds is they offer diversification, economies of scale, liquidity and are managed by a professional fund manager. Your investment is safe as capital markets are regulated by SEBI.

One of the major drawbacks of investing in mutual funds is there are fees and charges. But, you don’t have to worry about these charges as many mutual funds offer good returns over the long-term. Mutual funds offer much higher returns than conventional instruments like FDs and RDs.

In short, mutual funds are:

• Pooled investment from various investors.
• Regulated by SEBI.
• Professionally managed.
• Mutual funds may offer higher returns than FD and RD.
• You can invest in lump sum or SIPs.

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SEE ALSO: Different Types of Mutual Funds

Understand the Power of Compounding and Advantages of Investing in SIPs

Now, let's understand the significance of investing early in mutual funds.

The growth of your investment in mutual funds is powered by compounding. Compounding is Return on Return.

Example of Wealth Creation Through SIPs

By investing Rs 1 Lakh on a yearly basis from the age of 25 years, till your retirement (58 years), you would invest Rs 34 Lakhs. If you earned simple interest on this investment at a rate of 10%, then your overall returns would be just Rs 3.4 Lakhs at the time of maturity. When you retire, your corpus would be Rs 37.4 lakhs and this doesn’t look like a significant amount, considering your investment was a whopping Rs 34 lakhs.

Thankfully, mutual funds are powered by compounding. By earning return on return, that is interest on Rs 1.1 Lakh in the 2^nd year (considering the rate of interest offered is 10%) and so on, you would have accumulated a whopping Rs 2.7 crores, which is nearly 7 times your initial investment and simple interest.  If you exclude the simple interest, it is nearly 8 times your investment.

The below table shows the power of compounding in mutual funds:

Importance of Starting Early in Mutual Funds

Starting early in mutual funds is crucial as your investment base grows significantly with time.

Let’s consider the following example: your friend starts investing Rs 1 Lakh a year till his retirement age of 58 years, but he starts at the age of 35 years (10 years later than you). 

The difference between the returns earned by you and your friend is huge. Your friend would accumulate only Rs 97 lakhs while you accumulate Rs 2.7 crores. The table below summarizes the comparison of your portfolio with that of your friend’s:

Examples of Wealth Creation Through SIP

Compounding helps your investments grow at a rapid rate. Inflation reduces the worth of your investment. Today, Rs 45 lakhs might be sufficient to buy a house, but ten years later, Rs 45 lakhs may not be sufficient to buy a decent piece of land. With inflation, money loses its value with time. An Inflation of 8% makes your investment of Rs 1 Lakh lose half its value in 8 years.

If your investment doesn’t generate inflation beating returns, then inflation would reduce its worth to half in a period of 8 years (considering inflation is 8%).

SEE ALSO: How To Make Your First Mutual Fund Investment?

The below table summarizes the effect of inflation (8%) on an investment of Rs 1 lakh:

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