What Is Compounding in Mutual Funds?
Compounding is the process by which interest is added to an existing principal balance and previously paid interest. Thus, compounding can be interpreted as interest on interest, which has the effect of magnifying returns to interest over time, the so-called “magic of compounding.” When banks and financial institutions credit compound interest, they may employ a yearly, monthly, or daily compounding period. Compounding may occur on investments in which funds rise more rapidly or on debt in which the amount due may increase despite payments. Compounding occurs naturally in savings accounts; some dividend-paying investments may also benefit from compounding.
With compound interest, you earn interest on more than just your principal balance. Even your interest is subject to earning interest. Compound interest is when earned interest is added back to the principal balance, which then earns further interest, hence compounding returns.
Suppose you have Rs 1,000 in a savings account that yields 5% interest annually. In the first year, you would earn Rs 50, resulting in a new balance of Rs 1,050. In the second year, you would earn 5% interest on the bigger sum of Rs 1,050, or Rs 52.50, resulting in a new balance of Rs.1,102.50 at the conclusion of the second year.
Thanks to the enchantment of compound interest, the increase of your savings account balance would quicken as you collect interest on higher and larger sums over time. If you left Rs 1,000 in this hypothetical savings account for 30 years, maintained a 5% annual interest rate, and never added to the account, you would end up having Rs 4,321.94 in the account.
At various times, interest can be compounded, or added back to the principal. Interest, for instance, may be compounded annually, monthly, daily, or even continuously. The more frequently interest is compounded, the quicker the principal sum increases.
If you started with a Rs 1,000 sum in a savings account, but the interest you received compounded daily instead of annually, you would wind up with a total balance of Rs 4,481.23 after 30 years. If the interest was compounded more often, you would have earned an additional Rs 160.
Simple Interest vs Compound Interest
Simple interest and compound interest operate differently. Simple interest is determined only on the basis of the principle. When computing simple interest, earned interest is not compounded or re-invested in the principal.
Considered in terms of basic interest, a Rs 1,000 account balance earning 5% annual interest would pay you Rs 50 per year. The interest earned would not be added to the principle. In the second year, you would earn Rs 50 more. Commonly, simple interest is used to compute the interest payable on auto loans and other short-term consumer loans. In the meantime, interest on credit card debt increases, which is precisely why it appears that credit card debt may get so enormous so quickly.
In a perfect environment, you would want your savings and assets to accrue compound interest while your loans accrue simple interest.
Understanding Compound Interest
When computing compound interest, a few crucial aspects must be understood. Each plays a unique part in the final product, and certain variables can have a substantial impact on your returns. Here are the five most important factors involved in compound interest:
- Interest: This is the rate at which you earn or are charged interest. The higher the interest rate, the greater the amount of money you earn or owe.
- Starting principal: How much do you have to start with? How much money did you invest? While compounding increases with time, it all depends on the initial deposit or loan amount.
- The rate of compounding: Daily, monthly, or annual interest compounding determines the rate at which a balance rises. When making an investment, you should be aware of the frequency of interest compounding.
- Duration: How long do you expect to own an account or repay a loan? The longer you leave money in an FD or fixed income instrument, the longer it has to compound and the more you will earn or owe.
Power of Compounding
Albert Einstein is rumored to have remarked that the most powerful force in the cosmos is the principle of compounding. This power manifests itself in investment and finance through the concept of compounding returns. Compound interest means that you begin to earn interest on the interest you get, which accelerates the rate at which your money grows. For instance, if you have Rs 500 and earn 10% interest each year, you will have Rs 550 in a year if you earn 10% annually. Then, assuming you earn 10% interest on that Rs 550 the following year, you will have Rs 605 at the end of year two. The procedure continues until your initial Rs 500 may eventually be exceeded by the amount of interest accrued. This is one way that many successful investors grow their riches. You can take advantage on power of compounding interest through your investment portfolios.
The concept of the time value of money, which argues that the value of money varies depending on when it is received, is the basis for compounding interest. Rs 100 today is preferable to Rs 100 in a few years since it can be invested to earn dividends and interest income. Compounding enables the growth of funds. If you waited two years to receive the Rs 100, you would lose two years of compound interest earnings. The term for this is opportunity cost.
Opportunity cost is the loss of potential advantages when a course of action is disregarded. In this instance, the opportunity cost is equivalent to the amount of interest you would have earned if you had invested the money.
In our previous example, if you do not invest the Rs 500 in a 10% annual interest account, you will miss out on the possibility of making Rs 50 or more per year in interest. In 10 years, your Rs 500 might be Rs 1,296.87. However, if you do not invest it, it will still be Rs 500 ten years from now. When you comprehend the time worth of money, you will realize that compounding and patience are necessary for accumulating wealth.
Here’s another illustration: Suppose you are 30 years old and intend to retire at age 65 with Rs 1 million. You can afford to save Rs 800 every month in a savings account that yields an annual return of 8%. Will you be able to attain your goal? Using a compound interest calculator, you may determine that you would be able to convert that Rs 800 per month into Rs 1 million in 29 years, or six years earlier than you had originally planned to retire.
How Do Compounding Benefit Mutual Fund Investments?
Mutual funds are designed to maximize the impact of compounding. Investors profit as the price of fund units increases. If you invest with a long-term view, then the power of compounding will be maximized, allowing your investment to expand. This is especially true for mutual funds, where capital gains returns are reinvested to produce greater profits.
If you opt to invest Rs 1,000 every month in a mutual fund plan for the next ten years and the rate of return is 8% per year, your investment of Rs 1,20,000 will give a profit of Rs 1,82,946 after ten years. Now, if you choose to reinvest the money for a further 10 years, for example, it will increase even quicker to yield Rs 3,94,967. Unique to compounding is the fact that your previous investment, the return on investment, and each month’s new investment all contribute to additional gains. Example;
If you begin investing Rs 1 lakh per year and raise your investment by 10% per year, your money will grow as follows due to compound interest:
| Year | Opening Balance | Investment | Interest (10%) | Closing Balance |
| 1 | 100000 | 10000 | 1,10,000 | |
| 2 | 1,10,000 | 1,10,000 | 22,000 | 2,42,000 |
| 3 | 2,42,000 | 1,21,000 | 36,300 | 3,99,300 |
| 4 | 3,99,300 | 1,33,100 | 53,240 | 5,85,640 |
| 5 | 5,85,640 | 1,46,410 | 73,205 | 8,05,255 |
15*15*15 Rule In Mutual Funds
What is the 15*15*15 rule in Mutual Funds?
Now, let’s discuss the 15*15*15 rule for mutual fund investments. This law states that a Systematic Investment Plan (SIP) of Rs. 15,000 per month for 15 years can yield Rs. 1 crore in net worth at the end of 15 years. This assumes a 15% interest rate based on the Compounded Annual Growth Rate, or CAGR. The required net investment is Rs. 27 lakhs for a period of 15 years.
The 15*15*15 rule will assist you in accumulating some higher value.
The guidelines for 15*15*15 rule states that an investor can earn Rs. 10 crores with a SIP of Rs. 15,000 invested for 30 years and an expected CAGR of 15%. Therefore, the plan is to remain invested for a further 15 years in order to generate significantly bigger profits.
An important point to keep in mind is that although the assumed CAGR is 15%, an investment can yield 20% in one year and 7% in another. This is due to regular and frequently unanticipated market movements. The assumption is based on an average rate of 15% during the duration of the investment.
It is crucial to remember that equity investments are susceptible to market volatility and hazards and that this is merely a rule of thumb and 15*15*15 rule that can help you estimate returns but does not guarantee them.
Key Takeaways of 15*15*15 Rule:
- As a result of the fact that investments are similar to roller coaster rides when you invest in stocks your portfolio will not necessarily continue to grow or soar upwards. It is impossible to predict when the roller coaster will ascend or descend.
- Throw aside your Short-Term mentality and hold your investments for extended periods of time.
- Invest solely in mutual funds with a reasonable expense ratio in order to achieve a good return.
- To take advantage on the power of compounding, you should begin investing as early as possible.
Things to Consider for Maximizing Power of Compounding Benefit
The compounding principle is the same whether you invest 100 rupees or 10,000 rupees. However, if you have made a sizable investment, the interest you earn will also climb exponentially. The most effective way to harness the power of compounding is to increase your investments.
- Controlled Expenses
If your income is restricted, you might increase your savings by controlling your expenses. You can accomplish this by preparing a budget and identifying areas where you can minimize monthly expenses. Few realize that prudent spending can multiply money, which can then be reinvested for greater profits.
- Beginning Early
Beginning early is the key to maximizing investment returns. You should ideally begin investing as soon as you begin working. It is a myth to wait to invest until you have a higher income; rather, you should begin investing as soon as you begin earning. However, if you have already passed this level, begin investing immediately. Investing early provides a firm foundation for the growth of assets in the future, thanks to the compounding mechanism. If you do not understand how to calculate your return on investment, you might utilize an online calculator. Calculating improves investors’ ability to plan for the future.
- Practice Discipline
Discipline is the surest path to achievement. Creating a substantial nest egg and investing consistently from the outset are two approaches to achieving investment discipline. Skipping SIP payments is not a prudent choice because it undermines the financial discipline component. When you consistently invest money month after month, you increase your savings and gain discipline.
- Have Patience
Many stock market investors are constantly on the search for the quickest profits. However, in their haste to make a quick buck, they frequently commit egregious errors that result in much greater losses. As demonstrated by the preceding instances, compounding increases over time. Therefore, one must learn patience and adopt a long-term perspective when investing. Remember that you do not need to be a financial expert to enjoy compounding’s enormous rewards. Investing in accordance with the concept of compound interest enables every investor to generate money.
Conclusion
The 15*15*15 rule capitalizes on the power of compounding and is a long-term investing strategy. To develop money over time, investors should have a longer investment horizon. Long Term Mutual Fund Investments are ideal because they give the ability to swap between funds, redemption, transparency, and exposure to stock markets.
FAQs
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What are the different types of mutual funds?
Equity, debt, and hybrid funds are the three most prevalent types of mutual funds available in India.
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What is the best type of mutual fund to invest in?
An investor’s choice of mutual fund relies on their risk tolerance, return expectations, investing objectives, and investment horizon.
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