What Is The Power of Compounding & How Can You Use It?

For 13-year-old Rohan, compound interest was merely a mathematical concept that he had to remember the formula for in order to ace his exam. However, fast forward to a decade later, and Rohan, now 23, sees compound interest as his new best friend. He had recently decided to cash in his first paycheck and take baby steps into the world of mutual fund investments. What drew him to this particular long-term investment product was the benefit of the power of compounding.

Curious to know what this is all about? Let’s begin at the basics.

What is compounding?

Compounding is a process that can magnify your returns exponentially over a long period of time. With compounding, the interest that you earn on your initial investment is reinvested along with the principal amount. Effectively, this means that you earn interest on your interest. Unlike simple interest, where your initial investment remains fixed and your interest is not reinvested, compound interest is applied on the earnings or gains as well.

To explain this more clearly, let’s take a look at an example comparing simple and compound interest. Say you have invested Rs. 1,000 in investment option A, which gives you 10% simple interest, and another Rs. 1,000 in investment option B, which gives you 10% compound interest. Here’s how your investment in both these cases will grow after 2 years.

So, as you can see, the interest keeps on increasing in case 2, since the earnings are again invested back into the product. In the second year alone, you earn Rs. 10 more from compounding. This is what happens in mutual funds, where a profitable cycle is created in order to help your earnings grow exponentially. You can invest in mutual funds through the Moneyfy app from Tata Capital and experience first-hand how the power of compounding can help your money grow.

The frequency of compounding can vary from one fund to another. Some commonly used frequencies include annual, semi-annual, quarterly, or monthly compounding. In some cases, there is even the possibility of daily compounding, wherein your earnings are reinvested on a daily basis. This allows you to take maximum advantage of the power of compounding.

Additional Read:- Understanding Mutual Fund Terminologies

How does the power of compounding work in mutual funds?

When it comes to tapping into the power of compounding, time is your greatest ally. This is why long-term investment options allow you to utilize the potential of compounding more fully. Now, when it comes to mutual funds, there is generally no lock-in period. So, you can either choose to exit after a short period, or you can choose to remain invested for the long term.

For Rohan, it was a no-brainer that he wanted to remain invested in his mutual fund scheme for a minimum of 30 years, so he could really let compounding work for him. He also had the added advantage of starting his investment early in life, at 23 years of age. That, coupled with a long-term investment horizon, bears great news for Rohan’s money growing over the investment period, all thanks to the power of compounding.

What are some things you can do to take advantage of compounding?

If you, like Rohan, also wish to make use of the magic of compound interest in mutual funds, here’s what you can do to make the most of this tool.

The role of time in compounding

Compounding occurs when the returns from a mutual fund are reinvested to generate additional earnings over time. This means you earn returns not only on the amount you contribute but also on the returns they generate. The longer you stay invested, the greater the benefits of compounding you can reap.

For example, if you invest Rs. 10,000 every month with an average annual return of 8%, your investment will grow more significantly over 20 years compared to 5 years, thanks to the power of compounding.

Therefore it's important to stay patient and consistent to benefit from compounding on both the principal and the returns.

Get an early start

The earlier you start investing, the more compounding can work for you. In fact, this is why it’s advisable to invest right from the time you start earning, so you can get a head start. For Rohan, even before he was handed his first paycheck, he had a plan in place to begin investing. However, if that’s not the case for you, fret not. Because if the best time to start investing was yesterday, the next best time is now. Download the Moneyfy app and get started early.

Be a disciplined investor

Over the course of your investment, particularly in the early years, every penny you put into the fund matters. Compounding allows your money to make more money. So, if you are a disciplined investor, you can regularly contribute to your investment in a consistent manner. Regardless of the investment amount, the important thing is to invest regularly and make it a habit.

Don’t lose sight of your end goal

Compounding works best over the long term. So, pick a long-term investment and continue to invest regularly without losing sight of your end goal, which is to allow the power of compounding to work its magic. Patience is key, and you need to give your money time to grow. In fact, the longer it remains invested, the more it can grow.

Conclusion

You can use the magic of compounding to meet specific targets as well. There are many free online calculators that can show you how different amounts of money invested at varying rates can grow over the years. The Moneyfy calculator, for instance, is one such easy-to-use tool that can help you make smart and informed investment decisions.

Additional Read:- Understanding Mutual Fund Terminologies

If you choose to invest in mutual funds for the purpose of benefiting from compound interest, remember that it’s essential to consider it as a long-term investment and stay invested for as long as possible. Make your first investment through the Moneyfy app, which is easy to use and features a smooth and responsive user interface. With this app, you can complete your KYC digitally within minutes, so you can delve into the world of mutual fund investments without any delay.

Frequently asked questions

1. How to calculate compound interest in mutual funds?

To calculate compound interest for a mutual fund investment, you use the compound interest formula: A = P (1 + r/n) ^ nt.

2. Does inflation affect the returns?

Yes, inflation affects the returns on mutual fund investments, reducing the purchasing power of your investment over time. Therefore, it's important to consider inflation when evaluating long-term investment performance.

3. Why is a long-term investment horizon important for compounding in mutual funds?

A long-term investment horizon is important for compounding because the longer you stay invested, the more returns you will generate. These returns will then be added to your investment contributions to potentially earn even greater returns over time.

4. What is an example of a compounding effect?

Suppose you invest Rs. 5,000 in a mutual fund with 7% annual returns for 10 years. Using the compounding formula, your investment will grow to approximately Rs. 9,835 over time.