Compounding in mutual funds – Building wealth through time and patience

Compounding is a financial concept that enables an investor’s investment to grow over time, akin to a friendly genie multiplying your investments. It signifies the capability of an asset to produce returns, which in turn can be reinvested to generate even greater returns. As time progresses, this compounding phenomenon has the potential to facilitate significant wealth accumulation.

Let us understand the concept with an example. Consider planting a seed in a fertile patch of soil. With time, the seed sprouts into a small sapling, which then grows into a sturdy tree. As the tree matures, it produces more seeds, leading to the growth of additional trees. This cycle repeats, resulting in a forest, all originating from that single initial seed. Similarly, compounding enables small investments to grow steadily over time, multiplying and generating larger returns, much like the exponential growth of a forest from a single seed.

Unlocking Compounding with Mutual Funds

Mutual funds provide investors with a platform to leverage the power of compounding effectively. It can benefit from compounding through reinvesting dividends and capital gains. Moreover, Systematic Investment Plans (SIPs) are a popular way to achieve the benefits of compounding in mutual funds. By investing a fixed amount regularly, one can take advantage of market fluctuations through rupee cost averaging and benefit from compounding over time.

A disciplined approach to wealth creation is seen in the versatility of SIPs tailored to different financial goals. The power of compounding magnifies over a longer investment horizon, making early investment for specific goals, such as retirement, a key strategy.

Initiating savings early in one’s earning years, as opposed to later in life, allows for investments to grow exponentially, leading to a substantially larger corpus by the time you reach retirement age, thanks to the compounding effect working its magic over the decades.

Understanding the mechanics of Compounding

To understand compounding, let's delve into a hypothetical situation. Suppose, you invest Rs 10,000 in a mutual fund with a 10% annual return, at the end of the first year, you will have Rs 11,000. In the second year, you will earn 10% on Rs 11,000, which adds to your initial investment, leading to continuous growth of your wealth. When this occurs over decades, the final result can be unbelievable in terms of wealth creation. Hence it is said time spent invested matters more than timing the market.

Ways to maximise Compounding through SIPs

Begin early: Kickstart your SIP investments as soon as possible. The earlier you begin, the longer your investments have the time to compound and generate substantial returns.

Avoid premature withdrawals: Resist withdrawing funds from SIP prematurely. Early withdrawals can hinder the compounding effect and diminish the potential growth of investments.

Consistent and increased contributions: Stick to a consistent schedule of contributing SIPs regularly. Additionally, aim to gradually increase the amount you invest in your SIPs over time, if feasible. This disciplined approach ensures steady growth and enhances the compounding effect on your investments.

While it is true that starting late is better than never starting at all, the earlier you commence your investment journey, the more abundant the rewards you will harvest down the road.

However, it's crucial to keep in mind that, while compounding can significantly boost your returns, it is not a guaranteed outcome. The value of investment can fluctuate due to changes in market conditions, potentially leading to both increases and decreases in value over time.

Compounding is the magic component of your long term investment journey. However, the fruits of this magic are visible over time. Patience, a long-term orientation and remaining invested over decades are crucial for reaping the rewards of this financial magic.

Disclaimer: The article is authored by Bikash Kumar Agarwal,Hexagon Broking Private. The opinions expressed are those of the author and do not necessarily reflect the views of Business Insider India. Do your own research (DYOR) before deciding to invest in any financial asset class.

This article is published by the Insider Studios team. You can get in touch with them on insiderstudios@businessinsider.in.