Mutual funds allow investors to pool their money to invest in a diversified portfolio of securities, including bonds, stocks, money market instruments, etc. One of the main advantages of mutual funds is that they give investors the potential to earn a higher return through the power of compounding. The power of compounding is earning interest on previously earned interest.
This reinvestment of earnings can lead to impressive returns over time, particularly if the investment is left to grow for several years. Read on to learn how the power of compounding in mutual funds helps investors earn wealth and reach their financial goals faster.
How does mutual fund compounding work?
Compounding is often referred to as the “snowball effect” because it allows your investments to grow exponentially.
For example, let’s say you invest Rs 10,000 in a mutual fund that has an annual return of 10%. After one year, you will have earned Rs 1,000 in interest, and your total investment will be worth Rs 11,000. The following year, you will make 10% on the new total of Rs. 11,000, which comes out to Rs 1,100. So now your investment is worth Rs 12,100. In year three, you will again earn 10%, this time on Rs 12,100, which comes out to Rs 13,310. And so on.
Each year your investment grows more because you earn interest not only on your original investment but also on the interest reinvested from the previous year. Eventually, you will reach a point where the money you are reinvesting each year is greater than the original amount you invested.
Power of compounding in SIP
For example, starting with a monthly SIP of Rs. 10,000 at 12% would earn Rs. 8,094 as returns at the end of the year. If you reinvest this amount with your initial principal of Rs. 1,20,000, you will start earning interest on the new principal – Rs. 1,28,094.
By continuing this process, you will generate a future value of approximately Rs 8.25 lakhs at the end of 5 years, around Rs 23.23 lakhs after 10 years, and about Rs 99.91 lakhs after 20 years.
You can also check the power of compounding on your investments through online calculators. The power of compounding calculator is a handy tool that can help you determine how your money will grow over time. By entering factors such as the initial investment, the annual interest rate, and the number of years you plan to invest, the calculator can estimate your future returns.
How to leverage the power of compounding to become rich?
- Start early
Even if you can only invest a small amount each month, over time, those savings will add up and begin to compound. So, the earlier you start investing, the more time your money gets to grow. For example, if you start investing at age 25 and don’t withdraw your investments until age 65, you will have 40 years for compounding to work in your favor.
But if you wait until age 40 to start investing, you will only have 25 years for compounding to work.
- Save consistently
To see the true power of compounding, you need to save consistently. It means setting aside money each month without fail. You can set up standing instructions with your bank to allow automatic payment of mutual fund SIPs from your account on a specific date to establish a disciplined financial plan.
- Resist the urge to withdraw your initial investment unless necessary
Many people make the mistake of cashing out their investments as soon as they earn a return. However, this can be costly in the long run, as it reduces the opportunity for your money to grow through compounding.
- Invest and track your investments regularly
Investing and forgetting doesn’t work. You also need to monitor your investments regularly to make sure that your investments are on track to meet your goals. Keeping track of your investments can help you take advantage of market opportunities and can your investment strategy when necessary.
The power of compounding in stocks and mutual funds can help you multiply your investment returns and grow wealth. But it’s equally important to remember that compounding takes time. While trying to “time the market” may be tempting, this is difficult and can bring unexpected results.
A better strategy is to invest regularly in a well-diversified portfolio of mutual funds that match your risk tolerance and investment goals. By taking a long-term view and investing systematically, you can let the power of compounding work in your favor and help you reach your financial goals efficiently.