Many investors wonder how mutual funds 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 returns over the long term. To explore this concept further, let us start with a story.
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 where to put it, choosing products that will 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.
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Firstly, let us know what Compounding Interest is.
Compound interest is one of the most impactful financial concepts that allows your investment to grow exponentially over time. It occurs when the interest on an investment is calculated on both the initial principal and the accumulated interest from previous periods. This means that the interest is added to the principal, and then the next period’s interest is calculated on the new, larger amount. As a result, the growth of the investment accelerates over time, leading to significant returns in the long run. 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. This 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.
What is Rule 72 and how it works?
This Rule no.72 is simply one way to determine how long it will take to double your money, you can utilize the rule of 72. Simply divide 72 by the expected annual rate of return. For instance, if you plan to invest Rs 5 lakhs in equity mutual funds with an expected CAGR of 12% per annum, divide 72 by 12, which equals 6. This indicates that it will take 6 years 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.
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.
Suppose you invest Rs. 1,00,000 in two mutual funds with NAVs of Rs. 10 and Rs. 250 respectively. Let’s assume that both funds’ NAVs rise by 10% annually.
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 year 10, you would have Rs. 5.18 lakh. The Rs. 1 lakh difference in the investment amount results in a difference of Rs. 2.59 lakh in return.
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 is needed to become a Crorepati?
So many people have goals of becoming a crorepati. It is very easy, as per the illustration below, provided we start early and take the benefit of compounding in our favour. All you need is just a monthly investment of Rs 5,875 over a 25-year period, assuming 12% p.a. growth rate. If you start investing late and have only a 10-year period to achieve this goal, then you would need a monthly investment of Rs 44,636! Please have a look at the table below for more illustrations.
Conclusion
It is crucial to understand that the sooner you begin investing, the greater opportunity your money has to accumulate into a substantial amount. Initiating investments at an early stage enables you to harness the benefits of compound interest.
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