Power of compounding in mutual funds

Power of compounding

Imagine stacking away a pile of currency notes in a cupboard during your childhood years, which you earned as pocket money from your parents. After some years, say ten, you go back to that cupboard and take a look at that stack of notes. Surely, you would find as many notes of money as were stored by you originally, not a penny more, not a penny less.

Just consider this; had you made an investment of the same amount of money in a mutual fund, you would have reaped some return on that investment, by the simple virtue of leaving that money undisturbed in an investment.

The theory of compounding

Investing in mutual funds yields the benefit of compound returns, which means that an investor earns interest returns even on the interest earned by him. By addition of such returns in the amount of existing investments, the overall return on investment is amplified each time an interest is earned. Mutual funds reward an investor by staying invested for a long period of time.

Take for example

Let us take a simple example to demonstrate the effect of compounding on a mutual fund investment. A mutual fund which yields a return of 10% over a period of year, would amount to a closing balance of 110,000 at the end of one year, for an amount of 100,000 invested at the beginning of the year. Next year, the amount of 110,000 will be taken as the base amount on which an interest of 21,000 will be paid out at the rate of 10%, resulting in a corpus of 231,000, if an additional 100,000 is invested in the scheme. In an analogous manner, the return in terms of interest would amount to 171,500 for an amount of 500,000 invested over a period of five years. This simple example demonstrates the effect the compounding on an investment made in mutual funds that helps in reaping exceptional returns for an investor over a period of time.

On the other hand, had the same amount of money been invested in any scheme that offered simple interest, the investor would have earned a mere 50,000 at the rate of 10% at the end of five years.

The power play of time and investment amount

The results of compounding interest can be amplified by a greater quantum, simply by increasing the amount of investment each year. This seemingly magic trick works s by the simple use of mathematics and percentages, which denotes the compounding effect of a mutual fund investment.

Time is the most valuable and rewarding asset that proves to be a bonus for an investor in mutual funds. The effect of compounding produces such mass and unintuitive results that one can only gasp and exclaim about the magic of compounding for once. Going by historical performance, long term investing in mutual funds is more rewarding for an investor as the added returns, generate even higher corpus fund, on which an investor earns his returns.

Should you go for investing in mutual funds?

If you do have some spare money which could find better use in an investment portfolio, rather than stay idly stacked in low-interest bearing funds or savings account, investing in mutual funds is definitely a strong and promising proposition for you. In fact, mutual funds investments, especially through SIPs (Systematic Investment Plans), which requires small, yet steady investments each month for an extended period, have proved to be the best way for creating substantial wealth in the long run.

With the effect of compounding, you could earn an expansive range of returns, hardly envisaged in an ordinary investment.

 

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