Power of Compounding – How it Impact Mutual Funds

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What is compound Intrest?

According to Albert Einstein the compound interest is one of the most powerful forces of this universe. In the investment you will see the power of compound interest. Because here you will earn interest on interest. It accelerates the principal amount that you have invested. But you only take advantage of the power of compounding if you invest in the long-term. The compounding effect on the principal amount over a long period of time can generate a better return on the investment.

Basically it is the money multiplier strategy that is popularly used in mutual funds. So, when you invest in mutual funds the interest earned on the principal is reinvested to earn interest on interest. Let’s understand the power of compounding maths with this example.

Suppose there is a company ABC has invested Rs. 1 Lakhs in the mutual funds which gives 20% return annually that is compound interest. Below we have mentioned the calculative which shows you how much money a company will earn.

First-year = Rs 1,00,000 is the principal amount (the money ABC company has invested) + Rs.20,000 is the interest that is earned by the ABC company at the end of the year

Now here the compound interest shows its power

Second year = Rs.1,20,000 (Principal amount) + Rs. 24,000 is the interest that ABC has earned in the second year.

Hence the total money the ABC will get in the second year is Rs. 1,44,000 respectively.

It is one of the best strategies that allow investors to earn interest on interest or we can say that profit on profit. If you are looking for an investment strategy that offers you a higher gain at the end of the maturity then you should invest in the securities that offer you the power of compound interest.

Power of compounding and compound interest:

Year Principal Amount Compound Interest (20%) Simple Interest (20%)
1 ₹1,00,000 ₹1,20,000 ₹1,20,000
2 ₹1,44,000 ₹1,40,000
3 ₹1,72,800 ₹1,60,000
4 ₹2,07,360 ₹1,80,000
5 ₹248,832 ₹2,00,000

Investors only take the benefits of the power of compounding if they follow the terms that are mentioned below-

Starts Early

Investors who start investing in the securities as early as possible, the more interest they will gain. So, here the time matters the most. The person who invests at the age of 20 will get the more return of the investment compared to the person who invests in his 40’s.

Save Regularly

When you save steadily and invest the money rapidly you will get a better return of the investment which makes your financial planning stable and successful investor.

Shorter interval of compounding makes a greater impact

The power of compounding is nothing is the frequency of investing money in assets like monthly/ quarterly/ yearly. Many investors say that the shorter the interval the greater return you will get. But, at the same time many investors say that you only see the power of compounding when you invest in the long run. Whether you invest in the shorter or longer frequency the amount of return you will receive make you financially stable.
Now we are going to show you the power of compounding with this 15X15x15 rule of mutual funds. The primary strategy behind this rule is the compound interest.

For instance there is a Mr. X who has decided to invest rupees Rs.15000 on the mutual funds in equity funds for 15 years and generating a 15% return.

Now we are going to calculate his total investment amount that is 15,000 x 18 =  Rs. 27 Lakhs.

The profit generated on the invested amount is Rs. 73,00,000.

If we calculate the whole money Rs. 27,00,000 + 73,00,00 it would be 1 Crore.

Now Mr. X has made a decision to reinvest this amount by another 15 years, his wealth would increase 10 times.

So, investment amount in 30 years: Rs. 15000 x 360 = Rs. 54 Lakhs.

The total money is Rs. 10.38 crore

Mr. X has received a profit is Rs. 9.84 crore.

If you also want to earn the same return of the investment then you should understand the power of compound interest math. SIP is the best investment option to gain the benefits of the power of compounding. All you need is to invest money on the equity funds periodically just sit back relax and see the power of compound interest.

Benefits of Compounding

In the layman language the compound interest means interest on interest. Each time you gain interest on principal amount is added to your original amount and it becomes the principal of the next year investment.

Now, you may understand the working principle of compound interest. Now we are going to tell you the benefits of the power of compounding. So, let’s get started.

  • The simple yet powerful investment rule that takes your investment amount to the height where the revised amount will become greater than the original amount. For instance if you invest Rs. 100 at the interest rate of 8% for one year. However instead of withdrawing you wish to reinvest this amount for the next year. Then the principal amount for the next year is rupees 108 and the earning is 8% of Rs 108 which is Rs. 0.64 which is relatively higher than the previous year.
  • The longer you stay in the investment the better you gain the advantages of the compounding. Never forget the 15X15X15 rule of the mutual funds; it totally depends on the power of compounding.
  • When you invest your hard-earned money on the investments which are associated with the power of compound interest math you will get huge financial stability at the retirement period.
  • As you want to invest in mutual funds every year, so you need to save an amount to invest. Due to that your savings become higher than expenditure.

We hope now you understand the benefits of the power of compounding. If you really want to invest in the assets that give you an impressive return of the investment then invest in the Mutual funds.

Elements that Determine Compound Interest Return

In investment there are certain factors that influence the return rate at which your money is compound. Now, we are going to tell you the three important elements or factors that determine your compound interest return.

  • To take the advantages of the power of compounding you generally invest your money on the stocks. The total profit you earn is your total profit from capital gains and dividends.
  • The more time you give your investment to grow the better you will gain the power of the compound interest rate. For example, if you invest money in your early 20’s you will get higher gains than invest money in your 40’s. That’s why people invest their money in mutual funds and let it grow.
  • Because you deter paying taxes and have more money compounding over the years, you can end up with more money in retirement if you don’t have to pay taxes at all. When you placed your money on the investment like mutual funds, stocks, and dividends add to the amount in your account without being taxed. You get the deter taxes on your gains until you withdraw your money.

How does the power of compounding impact mutual funds?

Mutual funds are considered one of the best investment options. It is a wise investment choice because of the power of compounding. The high gains you will get can help you in achieving financial stability within an expected time. Generally mutual funds with moderate risk offer two types of earnings- capital gains and dividends. If an investor doesn’t withdraw his money from the mutual fund’s scheme then he will take the benefits of the power of compounding. Here, compounding means you will earn profit not only on your principal but also on the return generated by that investment. The longer you keep your money in the mutual fund scheme the better power of compound interest rate you will get.

Now we are going to tell you how the power of compounding works on mutual funds.

Because of the power of compounding maths, investors earn a profit on both principal and the return generated by the initial principal amount.

Let’s understand this better with this example   Suppose there is a Mr. Joe and Mr. Paul invested rupees Rs. 5000 each on the mutual funds of HDFC on august 14 for 5 years.

Mr. Joe has decided to keep his invested amount in the mutual funds whereas Mr. Paul has decided to withdraw the profit annually. The annualized rate of the return is 10.4% respectively over 5 years. Now understand how Mr. Joe will get benefited from the power of compounding maths than Mr. Paul.

  • At the beginning of the year the invested value is Rs. 5000 of Mr. Joe and Mr. Paul and they didn’t withdraw the money at the end of the year. The year-end value of the investment is 55,120
  • In 2015, Mr. Joe had decided to not withdraw the amount so his end value of the investment is 60,740. But, Mr. Paul has decided to withdraw money Rs. 5,120  his end value is 55,120
  • In 2016, Mr. Joe had decided to not withdraw the amount so his end value of the investment is 66,986. But, Mr. Paul has decided to withdraw money Rs. 5,120  his end value is 55,120
  • In 2017, Mr. Joe had decided to not withdraw the amount so his end value of the investment is 73,845. But, Mr. Paul has decided to withdraw money Rs. 5,120  his end value is 55,120
  • In 2018, Mr. Joe had decided to not withdraw the amount so his end value of the investment is 81,406 But, Mr. Paul has decided to withdraw money Rs. 5,120  his end value is 55,120
  • After five years of the investment period, the return of the investment Mr. joe has got is 31,406  whereas due to withdrawing money every year the return of the investment Mr. Paul has got is 25,600

We hope now you completely understand the power of compounding math.

You may Alos like to read: Estimating returns of Fixed Deposite

Thumb rules of investing with compound interest

Start as Early as Possible

It is one of the significant thumb rules of investing with compound interest. Because as soon as you start investing in the mutual fund’s schemes the better return you will get in your early retirement period. So, if you have not started yet, then invest now. It is always found that a 20-year-old investor is smarter than the man who starts investment in his 40’s.

Be regular

If you want to keep your portfolio healthy then you need to invest money on the assets periodically. When it comes to investing periodically many people say that their income is low and it is very difficult to save some money for the regular investment. For them, we only have one suggestion, think you are getting 10% less salary.

Patience is the Key

If you want to gain the advantages of the power of compounding maths you need to keep your money on the scheme for a longer time. Don’t take the decision in the run when you don’t see your money is growing. Investment with the compound interest is all about the patience.

Final Say:

Financewikki hopes you now completely understand the power of compounding. So, invest in the best mutual funds for regular monthly income and let your money grow.

Must Read: Low Investment Business Ideas in India | How to Save Money?

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