Understanding Compounding in Mutual Funds

What is Compounding?

Compounding is the process where your principal amount and the interest earned on it start earning more interest over time. This means you’re not just earning interest on your initial amount, but also on the interest that accumulates. People often refer to this as “interest on interest.”

Compounding can happen at different intervals, such as daily, monthly, semi-annually, or annually. The more frequently compounding occurs, the faster your investment grows. For example, an investment that compounds twice a year will grow more than one that compounds only once, and compounding four times a year will lead to even higher growth.

To find out how much an investment will grow with compounding, you can use this formula:

FV = P [(1 + r/n)^(n*t)]

Here’s what the terms mean:

• FV is the future value of your investment.
• P is the initial amount you invested (the principal).
• r is the annual interest rate (in decimal form).
• n is the number of times the interest is compounded in a year.
• t is the number of years the money is invested for.

Example

Let’s say you invest ₹10,000 at an annual interest rate of 5%, compounded monthly, for 3 years.

In this case:

• P = ₹10,000
• r = 0.05
• n = 12 (monthly compounding)
• t = 3 years

Plug these values into the formula:

FV = 10,000 [(1 + 0.05/12)^(12*3)

After solving, you’ll find that the future value of your investment will be ₹11,616.

This shows how compounding can help your money grow over time, depending on how often the interest is added and for how long you keep the investment.

How Does Compounding Impact Investment Returns?

Compounding plays a significant role in growing your investments over time. The process works by reinvesting the returns from your initial investment so that over time, you earn returns not just on your original amount but also on the accumulated gains. The longer your money stays invested, the more it benefits from compounding, resulting in a larger overall amount.

Here are some ways compounding impacts investments:

• Building Wealth Over Time: Compounding helps you accumulate a considerable amount of wealth by multiplying your returns over the years. Staying invested for a long time gives your money the chance to grow exponentially.
• Closing Gaps in Financial Goals: If you are working towards a specific financial target, compounding can help make up for shortfalls. By reinvesting your returns, you can reach your goals without needing to invest significantly larger sums upfront.
• Keeping Up with Inflation: Over time, inflation reduces the purchasing power of money. Investments that grow through compounding can outpace inflation, helping your wealth grow despite rising costs. This makes compounding a powerful tool for preserving and increasing the value of your money over time.

How Does Compound Interest Work in Mutual Funds?

Compounding basically means earning interest on interest. Mutual funds are marketable securities, and their returns depend on market movements. They don’t give a fixed interest to investors. Then why do people say the power of compounding in mutual funds helps you grow wealth in the long term? Do mutual funds give compound interest? Read to find out about compounding in mutual funds.

Before understanding compounding in mutual funds, we need to understand mutual fund returns. While there are various types of mutual fund returns, the following two are the most commonly used.

• Absolute returns

  Absolute returns are basically the profit you make on selling goods. It is simple to calculate and tells by how much your investment has grown, irrespective of the time period.

  Absolute return = ((Final value – initial investment)/(Initial investment))*100

  Absolute returns don’t change irrespective of the time period. Hence it gets difficult to compare the absolute returns of two investments.

  Let’s understand this with an example. Suppose you invest Rs 10,000 in two funds, Fund A and Fund B. Fund A grows to Rs 15,000 in 3 years, and Fund B grows to Rs 18,000 in 5 years.

  The return from Fund A and Fund B is 50% and 80%, respectively. Fund B gave you good returns, but it took five years, and Fund A gave you a 50% return in just three years. You cannot compare these two funds because you don’t know which fund made you better returns in a short period.

  This is where the annualized return comes into the picture. The limitations of absolute returns are taken care of by annualized returns.

• Annualized Returns or Compound Annual Growth Rate (CAGR)

  Annualized return or CAGR is the average return you earn per annum. It gives you a snapshot of the fund’s performance over a period of time, making it easy to compare the performance of two funds.

  Annualized return = ((1+absolute return)^(1/n))-1

  where n is the number of years.

  In the above example, Fund A’s annualized return is 14.47%, whereas Fund B’s return is 12.47%. This means Fund A gave an average return of 14.47% every year for three years, and Fund B gave 12.47% every year for five years.

  Fund A has performed better than Fund B. If you had stayed invested in Fund A for two more years, you would’ve made Rs 19,655, which is higher by Rs 1,655 than Fund B.

  If you stayed invested in these two funds for seven and ten years, your returns would look something like this.

  Investment Duration	Fund A	Fund B
  Five years	Rs 19,654	Rs 18,000
  Seven years	Rs 25,754	Rs 22,764
  Ten years	Rs 38,629	Rs 32,387

  The above table shows that the longer the investment duration, the higher the return. The returns have multiplied over the years, just like earning compound interest. Compounding works best in the long term.

Tips to Maximise the Power of Compounding

1. Reinvest Your Earnings

   When you earn dividends or capital gains from investments like mutual funds or stocks, consider reinvesting them instead of withdrawing. Reinvesting allows those earnings to grow alongside your initial investment, boosting the compounding effect over time.

2. Select Funds with Growth Potential

   To make the most of compounding, focus on choosing investments that show steady growth. Research mutual funds or stocks with a proven track record of strong performance over the past few years. Make sure the investments you pick align with your financial goals and how much risk you’re comfortable taking. This approach ensures your money is working in the right direction for you.

3. Stay Invested for the Long Term

   The longer you keep your money invested, the more you can benefit from compounding. Avoid frequently buying and selling your investments, as this can disrupt the growth process. Let your funds grow over time, allowing compounding to work to its full potential. Patience is essential when aiming for long-term financial growth.

4. Start Early

   You can accumulate more wealth by investing at a young age. You should start investing right from the time you start earning. But if you didn’t, then now is the right time to invest. Plan your financial goals and start investing in mutual funds today.

5. Be Consistent

   Consistency is the key to financial success. Make sure you set aside at least 20% of your monthly income for investments. Automate your investments to inculcate financial discipline.

6. Step Up Your Investment

   As you grow in your career, your income will also increase, and so will your expenses. Hence you have to increase your investments every year. This will help you reach your goals sooner than you planned and also help in beating inflation.

7. Practice Patience

   Mutual funds are marketable securities and are volatile in the short term. Don’t get disheartened when you see your portfolio red. Don’t look for short-term gains, as you might end up making huge losses. Be patient and stay invested until you reach your goal. However, you have to keep monitoring your portfolio every now and then.

Frequently Asked Questions (FAQs)