Many investors wonder how mutual fund returns are achieved and how the power of compounding in mutual funds plays a major role. When discussing mutual funds, the primary consideration is often the potential for investment growth over the long term. To explore this concept further, let us start with a story.
The Story of Alex: Grow Wealth with Compounding Interest
In a busy city, Alex sets out to make money grow using something called “compounding interest.” Even though Alex starts with just a little money, he is smart about choosing investment strategies that grow significantly over time. Even when things get tough, Alex keeps going, putting any extra money he makes back into the investments. Slowly but steadily, Alex’s money grows and grows, turning into a big success story. Along the way, Alex learns a lot about money and shares his knowledge with others, inspiring them to reach for their own financial goals.
To know more about “Wealth Creation” topic step by step, please refer to our blog. If you would like us to help you in your Wealth Creation, then do get in touch with us.
Firstly, let us know what Compounding Interest is.
What is Compound Interest?
Compound interest is one of the most impactful financial concepts that allows your investment to grow exponentially over time. It is calculated on both the initial principal and the
accumulated interest from previous periods. This leads to significant returns in the long run, making it one of the most powerful tools for wealth creation st
rategies.
Compound interest is a fundamental principle in the world of finance and
is utilized in various investment and savings vehicles to help individuals and businesses grow their wealth. It enables your income to grow gradually as your investments gain momentum, thanks to the compounding effect. Thi
s means that the interest earned is reinvested back into the principal amount, leading to exponential portfolio growth over time.
The concept of Rule 72 plays a crucial role in helping individuals make informed decisions about their finances with regard to compounding. These principles enable us to determine the timeframe required to double or triple our money at a given rate of return or interest rate. By offering a better understanding of how money grows, these techniques aid us in efficiently organizing and overseeing their financial affairs.
The Rule of 72 Explained
The Rule of 72 is a simple way to determine how long it will take to double your money. For instance, if you invest Rs. 5 lakhs in equity mutual funds with a CAGR of 12%, divide 72 by 12, which equals six years. This is an excellent tool for those wondering, “How to double your money?“
We can also estimate and calculate the rate at which you should invest your money to double it within your desired time. For e.g., if you are aiming to double your money in the next five years, then you will need to earn 14.4% return per annum on your investments to achieve the target (using Rule 72 divided by the total no. of years to target i.e. 5 72/5=14.4%)
*Please be aware that this is just an estimated time frame and may not represent the precise number of years*
The Rule of 72 is a valuable tool for evaluating the potential growth of investments, offering a straightforward and rapid method to estimate the time needed for your money to double or triple at a certain rate of return. grasping these principles can enable individuals to make knowledgeable decisions about their finances, ultimately leading to more efficient wealth management strategies.
Why Early Investing Matters: SIP for Long-term Investments
The power of compounding becomes even more significant with monthly SIPs (Systematic Investment Plans). For instance, if you wish to become a crorepati, starting early is essential. A monthly SIP of just Rs. 5,875 over 25 years at a 12% growth rate will get you there. Starting late means much larger contributions, as shown below.
Who can Benefit from Compounding?
It is incredibly useful for individuals who are looking to grow their wealth over time. By allowing the interest to be calculated not only on the initial principal but also on the accumulated interest from previous periods, compound interest enables investments to grow exponentially. This compounding effect leads to significant returns in the long run, making it a powerful tool for building wealth. Whether it’s through savings accounts, investment portfolios, or retirement funds, the use of compound interest helps to maximize the growth potential of funds and allows for the realization of substantial financial gains over time. It provides a clear incentive for individuals to start investing early and to allow their investments to grow over the long term, ultimately leading to a more secure financial future.
How does Compounding Interest Work?
Now consider this in the context of investments. Suppose you put Rs. 10,000 into a deposit with a 10 per cent annual interest rate and choose not to receive the interest payouts. In the first year, you would earn Rs. 1,000 in interest, resulting in a total of Rs. 11,000 (Rs. 10,000 + Rs. 1,000). This total amount would then earn interest in the second year, resulting in Rs. 1,100 in interest. This means that the Rs. 1,000 earned in the first year would in turn earn Rs. 100 in the second year. By the end of the second year, you would have Rs. 12,100. By the end of 10 years, the Rs. 10,000 would have grown to Rs. 25,937.
Mutual fund returns operate in a similar manner. If you invest Rs. 1 lakh in two mutual funds with NAVs of Rs. 10 and Rs. 250 respectively, and a year later both funds’ NAVs rise by 10 per cent to Rs. 11 and Rs. 250, your investment would be worth Rs. 1.1 lakh. At the end of the second year, both funds’ NAVs would again rise by 10 per cent, resulting in NAVs of Rs. 12.1 and Rs. 302.5 and the value of your investment growing to Rs. 1.21 lakh. The table below demonstrates how your investment value increases each year, assuming both funds’ NAVs rise by 10 per cent annually.
How Compounding Works in Mutual Funds
Suppose you invest Rs. 1,00,000 in two mutual funds with NAVs of Rs. 10 and Rs. 250, respectively. By the second year, assuming a 10% CAGR, the value of your investment will grow as demonstrated.
At the end of the first year:
- Fund 1’s NAV increases from Rs. 10 to Rs. 11 (10% increase)
- Fund 2’s NAV increases from Rs. 250 to Rs. 275 (10% increase)
The value of your investment at the end of the first year would be:
- Fund 1: Rs. 1,00,000 / Rs. 10 * Rs. 11 = Rs. 1,10,000
- Fund 2: Rs. 1,00,000 / Rs. 250 * Rs. 275 = Rs. 1,10,000
At the end of the second year:
- Fund 1’s NAV increases from Rs. 11 to Rs. 12.10 (10% increase)
- Fund 2’s NAV increases from Rs. 275 to Rs. 302.50 (10% increase)
The value of your investment at the end of the second year would be:
- Fund 1: Rs. 1,00,000 / Rs. 10 * Rs. 12.10 = Rs. 1,21,000
- Fund 2: Rs. 1,00,000 / Rs. 250 * Rs. 302.50 = Rs. 1,21,000
As you can see, the longer you remain invested, the more your investment grows. The impact of compounding is evident over a long period of time rather than just a couple of years. This is why it is always recommended that you start investing as early as possible.
Still unsure? Refer to the Paragraph above. If you had stayed invested for 10 years, you would have Rs. 2.59 lakh. If the 10 per cent rise in NAV had continued for another 10 years, you would have Rs. 6.7 lakh. However, if you had only stayed invested for the first five years, you would have only Rs. 1.61 lakh. Therefore, it is crucial to give your money time to work and not lose patience with your investments within the initial years.
Of course, compounding is more significant when you invest larger sums initially. For example, if you had invested Rs. 2 lakh in the above scenario, By the 10 years, the investment grows to Rs. 2.59 lakh. Staying invested longer leads to exponential portfolio growth, thanks to compounding.
The provided illustrations showcase the enduring impact of compounding, underscoring the importance of commencing investments early and allowing them to mature over time to ensure a more stable financial future. Understanding and leveraging the potential of compound interest can significantly enhance long-term financial prosperity and security.
Fundamentally, the influence of compounding increases with the duration of the period. Likewise, a higher investment amount results in a more significant compounding effect. As Albert Einstein already mentioned it is the eighth wonder of the world!
How Much Money Do You Need to Become a Crorepati?
If your goal is to become a crorepati, use the table below to calculate your monthly investment requirements. For example:
- Over 25 years, invest Rs. 5,875 per month.
- Over 10 years, you’ll need Rs. 44,636 per month.
Conclusion: Benefits of Early Investment
The sooner you begin investing, the greater the opportunity for your money to grow with compound interest. Whether your goal is retirement or financial independence, the benefits of compounding will ensure a secure financial future. As Albert Einstein said, compounding truly is the 8th wonder of the world!
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