Compounding, also known as compound interest, is a passive approach to earning money. Despite common belief, investors don’t typically identify the occurrence with anything other than fixed deposits.
Mutual funds, however, can potentially speed up the process of wealth generation by leveraging the power of compounding.
This article will examine the operation of compounding in mutual funds. Now let’s quickly go over the idea of compounding in general before we get there.
Compounding: What Does It Mean?
Compound interest, often known as compounding, refers to the fact that you earn interest on both the initial principal amount you spent and the interest continually added to it.
Primarily, it refers to reinvesting your initial investment’s gains rather than using them elsewhere.
For instance, if you make an investment of INR 100 at an annual rate of 10% interest, your principal investment would be INR 100, and your annual profit would be INR 10.
Nevertheless, if you decide to reinvest the earned interest instead of spending it, your main principal amount for the following year will be from INR 1 to INR 110, and you’ll get INR 11 in returns.
Although this might seem like a modest sum, if you allow compounding to work its magic over a lengthy period, it can significantly impact your investments.
How Compounding Works in Mutual Funds
You may already know that mutual funds invest your money in a variety of stocks. The fund company that oversees the mutual fund receives dividends that these equities occasionally declare.
Following that, the fund company will pay you the dividend in cash proportionate to the number of units you own. A dividend reinvestment plan is an option for investors who want to reap the benefits of compounding.
The dividends you receive while choosing such a plan are periodically reinvested into a single mutual fund, similar to a compounding fixed deposit. This repatriation of earnings results in you owning more units of the fund.
The number of units you eventually acquire will be much more than what you’d have possessed when you wouldn’t choose the reinvestment alternative when such dividend reinvestment is conducted over a long time frame, say for roughly ten years.
To better illustrate how compounding functions in mutual funds, here is an example.
| Year | Opening Balance | Investment (INR) | 15% Interest | Closing Balance (INR) |
| 1 | Nil | 2,00,000 | 30,000 | 2,30,000 |
| 2 | 2,30,000 | 2,30,000 | 34,500 | 2,64,500 |
| 3 | 2,64,500 | 2,64,500 | 39,675 | 3,04,175 |
| 4 | 3,04,175 | 3,04,175 | 45,626.25 | 3,49,801.25 |
| 5 | 3,49,801.25 | 3,49,801.25 | 52,170.1875 | 4,02,271.438 |
Total Investment = INR 3,49,801
Valuation After 5 Years = INR 4,02,271
Interest Earned = INR 52,170
Perks of Compounding
The value of time is one of the main advantages of compounding that investors may appreciate. Your investments could grow quickly if you receive returns over time, and the yields on those returns could create additional returns.
It’s beneficial to save money and collect compound interest each year. But what if you made a set monthly investment? Over time, this modest action might increase your returns. Your returns may grow significantly more quickly if you consistently invest over time.
Final Words
Regardless of the tool you select, investing consistently is the key. There is no ideal moment to invest, and getting started as soon as possible is highly advised.
Or, to put it another way, the moment is now to invest! Your procrastination will inevitably become longer if you overthink a decision or wait for “ideal” market conditions.
Conduct your research, comprehend the investment you’re making, weigh the dangers, write down your objectives and the time frame for the corresponding investment, and then jump in.
