Understanding the power of compounding



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 you 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. However, 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 shall compare and analyse the return and the expense ratio to select the best one. This is because even a 1% increase in the expense ratio can create a huge difference in the returns you receive. Let’s 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. Scheme A provides an annual return of 13% per annum, whereas Scheme B provides a return of 14% per annum. Let’s see how much wealth you will accumulate at each 10-year interval:

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 wealth started multiplying magnificently. This 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 the 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 to understand how much return you can earn in how many years and at what interest rate.


Real-Life Example for Compounding – Warren Buffet


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While you understand how compounding works in SIP, let’s 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, who was in first place on the Forbes list for 13 consecutive years.


If you analyse Warren Buffet’s net worth in different timelines, you will notice that 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. Then, it was only after crossing 56 years of age that he entered the billionaire elite club with his net worth crossing the $ 1 billion mark. And 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’s the power of compounding. Warren Buffet is a real-life example to understand how compounding works in real life. And that’s true not only for investing but also for your daily habits. Good habits consistently performed will start providing compounding results after a particular stage. The same applies to bad habits.


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 select dividend-paying mutual funds, the compounding effect reduces as the profits are distributed instead of reinvested.


If you want to multiply your wealth, it’s 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.



Interested in how we think about the markets?

Read more: Zen And The Art Of Investing


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