Unlocking the power of compounding: Mutual funds and the magic of long-term growth

Compounding, the silent force that transforms small investments into substantial wealth over time, is a key player in the context of finance. In case you are new to investing, it is essential to begin any investment conversation with a focus on compounding. Compounding is the concept of generating interest not just on your initial investment but even on the interest constituent and returns accumulated from prior periods.

It acts as a powerful means to potentially grow your investments over time by consistently remaining invested in the market. Mutual funds are a strategic investment option that unlocks the power of compounding for long-term growth.

Understanding compounding

What is compounding?

As mentioned above, compounding is the concept of earning returns on returns already earned from your investment. So, your investment generates earnings not only from the original principal component but also accumulates additional earnings from past compounding periods. This steady growth contributes to the constant wealth enhancement as you stay invested, facilitating the attainment of your financial goals.

Whether you are starting on your financial journey through a systematic investment plan like with SIP mutual funds or aiming to enhance your current mutual fund investments, a grasp on compounding is essential. Knowing how compounding operates allows you to secure higher returns on your investments, providing the means to strategically plan for significant life goals.

The magic of time

Ever wondered how a modest snowball transforms into a colossal snow boulder while rolling downhill? The same dynamic plays out in your finances, thanks to the magic of compounding. Compounding's power lets your investment in a lump sum mutual fund or SIP investment to burgeon exponentially. Here's an example.

Imagine investing Rs 20,000 with an annual return of 8%. In the first year, your investment grows by Rs 1,600, totalling to Rs 21,600. Rather than withdrawing the Rs 1,600 profit, you reinvest it. Come the second year, your investment grows by another 8%, this time on Rs 21,600, yielding Rs 1,728. This pattern persists, and your wealth multiplies due to the expanding base amount. Over time, compounding becomes a formidable force, significantly enhancing your investment returns.

Making the most of the power of compounding depends on staying invested for an extended period, permitting the returns to compound. The more prolonged your investment tenure, the more profound the compounding effect. Initiating early investments and consistently contributing further for the long term magnify the advantages of compounding.

Mutual funds and compounding

How do mutual funds harness compounding?

Mutual funds play an essential role in compounding by pooling funds from distinct retail investors and strategically investing in a diversified portfolio of securities, like bonds or stocks. This pooling strategy magnifies the compounding effect, as the returns earned on the entire fund benefit each investor.

Types of mutual funds ideal for compounding

To maximise the compounding potential in mutual funds, consider equity mutual funds for dynamic stock-based capital appreciation over the long term. Despite inherent risks, historical evidence supports their ability to outpace inflation, making them apt for compounding enthusiasts. Patience is crucial as market fluctuations allow compounding to transform volatility into long-term wealth.

Also, to make the most out of compounding, you may consider investing in the best mutual funds or top mutual funds through the SIP mode. SIPs offer a disciplined approach, involving regular fixed-amount investments at predetermined intervals. This mitigates market volatility and enhances compounding returns. Rupee-cost averaging inherent in SIPs lets you buy more units when markets are low and fewer when markets are high, proving beneficial for consistent, long-term compounding. Combining the growth potential of equity mutual funds with SIPs establishes a resilient foundation for sustained wealth accumulation through compounding.

The compounding effect in action

Case study of long-term growth

Suppose you decide to buy a mutual fund and for this make an investment of Rs 3 lakh at an 11% rate of return today, then this can yield a maturity amount of approximately Rs 5,05,517 in five years. This signifies that without exerting additional effort, you have generated Rs 2,05,517 owing to the power of compounding.

Comparing compounded returns

Let’s understand the effect of compounding with another example.  

For a 25-year-old investor looking to accumulate a retirement corpus of Rs 3.22 crore by 60 years of age, a monthly contribution towards SIP of Rs 5,000 at an assumed annualised return rate of 12% is a prudent roadmap. On the contrary, a 45-year-old eyeing to attain the same goal over the next 15 years would require committing to a monthly SIP of Rs 64,500 at the same return rate. Such figures emphasise the impact of beginning with early investment in mutual funds for meeting long-term goals.

Importance of a calculator

A mutual fund calculator simplifies the intricate calculations behind compounding. It serves as a practical instrument to estimate how your investments could grow over the years.

How to use the compound interest calculator?

To witness the potential growth of your investment, enter your initial investment, expected rate of return, and time horizon into the compound interest calculator. The result provides a tangible illustration of the magic of compounding at work.

Conclusion

To leverage the actual potential of your mutual fund, remember to commence your investment journey early, remain invested for the long term, and explore the diverse types of mutual funds available. Before you invest in a mutual fund, ensure to use an online mutual fund calculator to estimate the accurate monthly or lump sum investment you must make to attain your corpus amount. By leveraging the power of compounding, you are not merely buying into an investment; you are actively investing in your financial future.

Disclaimer: No Deccan Chronicle journalist was involved in creation of this content. The group also takes no responsibility for this content.