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The Power of Compounding: Accelerating Wealth Creation with Mutual Funds

If we had to personify ‘compound interest’ and imagine what it looked like – one thing is for sure – we’d picture it with a power pose and a cape!

Because compounding is a superhero – Captain C, we’ll call it!

Compound interest is a powerful concept in investing, and it plays a significant role in wealth creation over time, especially for young investors in India. Let’s take a look at the math behind it before we get into the nitty-gritty of it all – 

Here – 

A – Final Amount

P – Principal Amount

r – Rate of Interest

n – Number of times the interest is applied for each time period

t – Number of time periods

If you have the data that corresponds to all these variables (P, r, n and t), then you should easily be able to determine your total capital (A) at the end of your investment horizon. But, talk is cheap – let’s see this formula in action to understand how it really works – 

Let us assume that you are investing ₹100 at 10% interest per year. When you opt for compound interest, then for the second year, your principal amount becomes ₹110. You will now make a 10% interest on this investment amount (i.e., ₹110), making your total amount at the end of the second year ₹121. And the pattern continues for the whole tenure of your investment. 

Take a look at this table to see how this ₹100 looks when compounded over ten years.

Take a look at this table to see how this ₹100 looks when compounded over ten years.

Year

(P) – Principal Amount (₹)

(I) – 10% Interest Amount (₹)

(P+I) – Closing Amount (₹)

1

100

10

110

2

110

11

121

3

121

12.1

133.1

4

133.1

13.31

146.41

5

146.41

14.64

161.05

6

161.05

16.10

177.15

7

177.15

17.71

194.86

8

194.86

19.48

214.34

9

214.34

21.43

235.77

10

235.77

23.57

259.34

So, with the application of compound interest, you can turn ₹100 into ₹259.34 in a span of 10 years. Just imagine what a slightly larger amount (invested consistently everyday!) will earn you. 

Now that you have seen how compound interest works, we can delve into its key benefits, when clubbed together with mutual fund investments. As the fund generates earnings, these earnings are reinvested, and over time, they start generating their own returns. This cycle of reinvesting and generating returns on the reinvested earnings leads to compounding, resulting in big gains!

Mutual fund compounding is one of the key reasons why mutual funds are popular modes of investment in India. When it comes to mutual funds, compound interest refers to the reinvestment of earnings generated by the fund, which leads to an exponential growth of wealth. 

Here’s what a successful cycle of investment looks like when it is leveraging compound interest.

  • Initial Investment: You contribute a certain amount to a mutual fund.
  • Returns: The mutual fund generates returns on the invested amount.
  • Reinvestment: Instead of withdrawing the returns, you reinvest them back into the mutual fund.
  • Increased Investment: Reinvested returns increase the investment amount, leading to higher potential future returns.
  • Repeat: The process of reinvesting returns continues over time, compounding the growth of wealth.

Compounding can be a powerful tool for wealth creation, and it should be wielded as such! Here are some of the main benefits of compounding in mutual funds that can help young investors create returns over time – 

1. Time Horizon: Young investors (you!) have a longer investment horizon, allowing you to take full advantage of compound interest. Remember – the longer the investment is held, the more time the returns have to compound and grow.

2. Starting Early: Time is your ally! If you are starting early – kudos! It will allow you to contribute smaller amounts initially and benefit from the exponential growth potential over time. Like we say at Deciml – no amount is too small – even small investments can turn into significant wealth when Captain C steps in to save the day!

3. Regular Investments: Young investors can set up systematic investment plans (SIPs) for mutual funds to invest a fixed amount at regular intervals. SIPs promote regular investing, ensuring a continuous flow of funds to benefit from compound interest over an extended period. You can also automate your investments to a daily basis, like with Deciml, to make investing easy and leverage the miracle of compounding.

4. Reinvestment of Dividends: Dividends received from mutual funds can be reinvested to further take advantage of compounding while increasing your principal investment. Reinvesting dividends allows for holistic growth – your capital and returns are both increasing!

5. Long-Term Goals: Young investors often have long-term financial goals such as retirement planning or purchasing a house. Compound interest can help you accumulate substantial wealth over time to achieve these goals. The key here is to opt for a longer investment horizon.

Due to compounding the potential wealth created by you can be significantly higher than the initial amount invested by you. The exact amount of your returns will of course depend on the fund’s performance, but assuming the fund performs well, compound interest is a good way to maximize your returns in a fixed time period.

The power of compounding can help young investors in India create substantial wealth over time, provided they remain invested for the long term. It is also important to remember that while compound interest can greatly benefit young investors, selecting the right mutual fund, understanding the risks involved, and conducting regular portfolio reviews are undoubtedly essential. 

FAQs

  • Do mutual funds give compound interest?

Yes. Most mutual funds in India will offer compounding interest on your investment.

  • How do mutual funds compound?

As the mutual fund generates earnings, these earnings are reinvested, and over time, they start generating their own returns. This cycle of reinvesting and generating returns on the reinvested earnings leads to compounding, resulting in good returns.

  • How long do I need to stay invested for the benefits of compounding to kick in?

Apps like Deciml offer compound interest on your investment from the very next day. However, the investment horizon itself is entirely up to you, as long as you keep in mind that the longer you stay invested, the better your returns will be through compounding.

  • What is the investment cycle like with compound interest?

Initial Investment > Returns > Reinvestment > Increased Investment > Repeat 

  • What is the main difference between simple interest and compound interest?

With simple interest, you are only earning interest on your principal amount, whereas, with compound interest, you are earning interest on your interest as well!

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