What is Compounding?
Compounding, in simple terms, means the interest levied on both principal and interest components. It contrasts with simple interest, where you earn interest only on the principal component.
Suppose you have Rs. 1000, and lend it to someone @ 12% per annum. Now, in the case of simple interest, you will earn Rs. 150 each year.
However, in the case of compound interest, you will earn Rs. 150 in your first year. In the second year, you will earn Rs. 172.5 [(1000+150) * 15%]. In the third year, you will earn Rs. 198.38 [(1000+150+172.5) * 15%]. The interest amount will keep on increasing each year.
Compounding in Mutual Funds
Mutual funds are some of the best compounding investments to compound your wealth. The longer you stay invested, the more your wealth compounds.
However, while selecting the mutual funds, you should compare and analyse the return and the expense ratio to choose the best fund. It is because even a 1% increase in the expense ratio can create a huge difference in the returns you receive.
This simple example will explain how compounding in mutual funds works:
Suppose you start a SIP investment of Rs. 10,000 each month. You have two schemes to invest in. Scheme A provides a return of 13% per annum, whereas Scheme B delivers a return of 14% per annum.
Let us see how much wealth you will accumulate at a 10-year interval for each scheme.
| Years | Total Amount Invested | Scheme A @ 13% Returns | Scheme B @ 14% Returns |
| 10 | 12 lakhs | 24.66 lakhs | 26.20 lakhs |
| 20 | 24 lakhs | 1.14 crores | 1.31 crores |
| 30 | 36 lakhs | 4.42 crores | 5.55 crores |
| 40 | 48 lakhs | 16.35 crores | 22.61 crores |
| 50 | 60 lakhs | 59.83 crores | 91.23 crores |
Notice the difference?
There are two important observations here concerning SIP compounding interest:
- The amount of wealth increased slowly in the initial years. However, after crossing 30 years, the amount started multiplying magnificently. It is because compounding shows its magic at later stages after a certain amount of time has passed.
- A 1% return difference can create a difference of Rs. 31.4 crores (Rs. 91.23 crores – Rs. 59.83 crores) for the same amount invested over the same tenure. That’s a huge difference! This difference is also due to compounding — the 1% difference in returns compounded for 50 years to generate this difference.
To further understand mutual fund compounding, you can use the MF compounding interest calculator. It helps you comprehend how much return you can earn in how many years and at what interest rate.
Real-Life Example for Compounding: Warren Buffet
While you understand how compounding works in SIP, let us take a real-life example of how compounding can make you wealthy.
Most people have heard of Warren Buffet. He is an idol for most investors, the reason being that he accumulated generational wealth through investing. In 2008, he became the wealthiest person in the world with a net worth of $62 billion by overtaking Bill Gates. The latter was in first place on the Forbes list for 13 consecutive years.
You will observe something interesting if you analyse Warren Buffet’s net worth in different timelines. There has been a significant rise only in the later stages of his life.
He became a millionaire at 30, crossing the $1 million mark. After reaching 56 years of age, his net worth crossed the $1 billion mark, and he entered the billionaire elite club. His net worth (as of March 2022) was $117 billion.
To put it into perspective, he accumulated more than 99% of his wealth only after his 50th birthday.
That is the power of compounding. Warren Buffet is a real-life example to understand how compounding works. It is not only for investing but also for your daily habits. Good habits consistently performed will start providing compounding results after a particular stage.
In a Nutshell
Mutual funds and SIP are some of the best ways to reap compounding benefits. However, the profits must be reinvested into the scheme to reap compounding benefits. Therefore, you should understand the terms of the scheme before investing.
If you want to multiply your wealth, it is time you start investing and see the power of compounding mutual funds. The earlier you start, the more time your investments get to accumulate and compound.
If you haven’t already started your investing journey, visit Kuvera – Your Safe Space to Invest. Kuvera is an online wealth management platform which guides you in making smart investment decisions. Create your account on Kuvera today to learn more about compounding in mutual funds.
FAQs
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Which instruments can offer compounding benefits?
Every instrument in which returns are reinvested instead of being paid to the investor can offer compounding benefits. However, the returns of compounding vary across each investment.
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Do dividend-paying mutual funds offer compounding benefits?
Unitholders receive dividends from dividend-paying mutual funds pay. As a result, there is little scope for compounding in this case.
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Are there any disadvantages to compounding?
As far as investments are concerned, compounding is an investor’s friend. However, applying compound interest on your borrowings can be a serious disadvantage for your finances.
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