Magic of Compounding: Have you ever wondered how some people manage to create wealth by investing in mutual funds? How do they choose the right funds, and how long do they stay invested? The answer lies in the magic of compounding, which is one of the most powerful concepts in finance. Compounding is the process of earning interest on interest, or returns on returns, over time. It can help you multiply your money exponentially, provided you invest wisely and patiently.
The magic of compounding:
In this blog post, we will explore the magic of compounding in mutual funds, using a real-life example of a fund that has delivered stellar returns over the past decade. We will also discuss some tips on how to harness the power of compounding for your financial goals.
What is compounding in mutual funds?
Compounding in mutual funds is the phenomenon of earning returns on the returns that you have already earned from your investments. For example, suppose you invest ₹1 lakh in a mutual fund that gives you a 10% annual return. After one year, your investment will grow to ₹1.1 lakh. Now, if you reinvest the ₹10,000 that you earned as a return, you will have ₹1.21 lakh at the end of the second year. This is because you will earn 10% on the original ₹1 lakh as well as the ₹10,000 that you reinvested. This process will continue year after year, and your money will grow faster and faster as you keep reinvesting your returns.
The formula for calculating the future value of an investment with compounding is:
FV = PV * (1 + r)^n
Where,
FV = Future value of the investment
PV = Present value of the investment
r = Annual rate of return
n = Number of years
Using this formula, you can calculate how much your investment will be worth after a certain period of time, given a certain rate of return.
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How does compounding work in mutual funds?
Mutual funds represent an investment vehicle that consolidates funds from numerous investors, directing them into a diversified portfolio of securities encompassing stocks, bonds, and more. Mutual funds offer different types of schemes, such as equity, debt, hybrid, etc., that cater to the different risk profiles and investment objectives of investors. Mutual funds are managed by professional fund managers who aim to generate returns for investors by following a certain investment strategy and philosophy.
Mutual funds work on the principle of compounding as they reinvest the returns that they earn from the underlying securities. For example, if a mutual fund invests in stocks that pay dividends, the fund will reinvest the dividends in buying more stocks. Similarly, if a mutual fund invests in bonds that pay interest, the fund will reinvest the interest in buying more bonds. This way, the fund will increase its assets and generate higher returns over time.
The compounding effect in mutual funds depends on two factors: the rate of return and the time horizon. The higher the rate of return, the faster the money will grow. The longer the time horizon, the more the money will benefit from compounding. Therefore, to maximize the compounding effect of mutual funds, you need to invest in funds that offer high returns and stay invested for a long period of time.
A real-life example of the magic of compounding in mutual funds
To illustrate the magic of compounding in mutual funds, let us take a real-life example of a fund that has delivered exceptional returns over the past decade. The fund is the Nippon India Growth Fund, which is an open-ended equity scheme that invests predominantly in large-cap and mid-cap stocks. The fund follows a growth-oriented investment style and aims to provide long-term capital appreciation to the investors.
Now, let us see how much your investment of ₹1 lakh in the Nippon India Growth Fund would have grown to in 10 years, using the compounding formula:
FV = PV * (1 + r)^n
FV = 1,00,000 * (1 + 0.1982)^10
FV = 7,08,347
This means that your investment of ₹1 lakh in the Nippon India Growth Fund would have grown to ₹7.08 lakh in 10 years, which is a whopping 7 times increase in your money. This is the magic of compounding in mutual funds.
How do you harness the power of compounding for your financial goals?
The example of the Nippon India Growth Fund shows how compounding can help you create wealth by investing in mutual funds. However, not all mutual funds can deliver such high returns, and not all investors can stay invested for such a long time. Therefore, you need to follow some tips to harness the power of compounding for your financial goals:
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Start investing early and regularly. The earlier you start investing, the more time you will have to benefit from compounding. The more regularly you invest, the more you will accumulate and grow your money. You can use the [SIP calculator] to find out how much you need to invest every month to achieve your desired corpus.
Stay invested for the long term and avoid frequent withdrawals or switches. The more you withdraw or switch your money, the more you will lose out on the compounding effect. You should only withdraw or switch your money when you need it for your financial goal or when there is a change in your risk profile or investment objective.
Review your portfolio periodically and rebalance if needed. You should monitor your portfolio at least once a year and check if it is aligned with your financial goals and risk profile. You should also check if the mutual fund schemes that you have invested in are performing well and meeting your expectations. If not, you should rebalance your portfolio by adding or removing some schemes or changing the allocation of your money.
What is the difference between CAGR and absolute returns?
CAGR and absolute returns are both measures of investment performance, but they differ in how they calculate the returns and how they account for the time period of the investment.
Absolute returns show the total gain or loss of an investment, irrespective of the time period. They are expressed as a percentage of the initial investment value. For example, if you invest ₹1 lakh in a mutual fund and after one year it becomes ₹1.2 lakh, your absolute return is 20%. However, absolute returns do not tell you how fast or slow your investment grew or fell. They also do not compare your investment to any other benchmark or alternative.
CAGR stands for compounded annual growth rate. It shows the average annual rate of return of an investment over a specific period of time, assuming the returns are reinvested. It is expressed as a percentage of the initial investment value. For example, if you invest ₹1 lakh in a mutual fund and, after five years, it becomes ₹1.8 lakh, your CAGR is 12.47%. CAGR tells you how much your investment has grown or declined per year on average. It also allows you to compare your investment to other investments or benchmarks with different time periods.
To summarize, absolute returns are simple and straightforward, but they do not account for the time value of money or the opportunity cost of investing. CAGR is more complex and realistic, but it requires more information and calculation. CAGR is a better measure for long-term investments, while absolute returns can be used for short-term investments.
How do I calculate my SIP amount?
The expected rate of return on your investment (p.a.)
The duration of your investment (in years)
You can use an online SIP calculator tool to estimate the future value of your SIP investment based on these inputs. For example, you can use the SIP calculator from Groww or the SIP calculator from HDFC Bank to find out how much your monthly SIP investment will grow over a certain period of time.Alternatively, you can also use the following formula to calculate the future value of your SIP investment manually:FV = P * ( { [1 + i]^n – 1} / i) * (1 + i)BEST BOOK: MUTUAL FUND SIP👉CLICK HERE
Where,
FV = Future value of the investment P = SIP amount i = Periodic rate of return (monthly or quarterly) n = Number of payments
For example, if you invest ₹10,000 per month for 10 years at a rate of return of 12% p.a., then the future value of your SIP investment will be:
FV = 10,000 * ( { [1 + 0.01]^120 – 1} / 0.01) * (1 + 0.01) FV = 23,26,248
This means that your investment of ₹10,000 per month for 10 years will grow to ₹23.26 lakh, which is the power of compounding in SIP.
Can you explain the concept of risk in investing?
There are different types of risk in investing, such as:
Market risk: The risk of losing money due to changes in the market prices of securities, such as stocks, bonds, commodities, etc. Market risk can be affected by factors such as supply and demand, investor sentiment, interest rates, inflation, etc.
Credit risk: the risk of losing money due to the default or failure of the issuer or borrower of a security, such as a bond, loan, or mortgage. Credit risk can be affected by factors such as the financial health, credit rating, and reputation of the issuer or borrower, as well as the terms and conditions of the security.
Liquidity risk: the risk of losing money due to the inability to buy or sell a security quickly and easily at a fair price. Liquidity risk can be affected by factors such as the availability of buyers and sellers, the trading volume, the market depth, the transaction costs, etc.
Currency risk: the risk of losing money due to changes in the exchange rates of foreign currencies. Currency risk can be affected by factors such as the economic performance, monetary policy, political stability, trade balance, etc. of the countries involved in the currency exchange.
Inflation risk: the risk of losing money due to the decrease in the purchasing power of money over time. Inflation risk can be affected by factors such as the growth of the money supply, the demand for goods and services, production costs, tax policies, etc.
There are several ways to measure and manage risk in investing, such as:
Standard deviation: a statistical measure of the volatility or dispersion of the returns of an investment. A high standard deviation indicates a high degree of risk, as the returns can vary widely from the average or expected return.
Beta: A measure of the sensitivity or correlation of the returns of an investment to the returns of the market or a benchmark. A beta of 1 indicates that the investment moves in sync with the market or the benchmark. A beta greater than 1 indicates that the investment is more volatile or risky than the market or the benchmark. A beta less than 1 indicates that the investment is less volatile or risky than the market or the benchmark.
Sharpe ratio: an indicator quantifying the surplus return in relation to the risk undertaken in an investment. The excess return is the difference between the actual return and the risk-free return, which is the return of a safe and liquid investment, such as a Treasury bill.The level of risk is assessed through the standard deviation of the returns. A high Sharpe ratio indicates a high degree of risk-adjusted return, as the investment generates more return for the same level of risk or less risk for the same level of return.
Diversification: a strategy of spreading the investment across different securities, asset classes, sectors, industries, geographies, etc. to reduce the overall risk of the portfolio. Diversification works by reducing the impact of any single or specific risk factor on the portfolio, as the losses from one investment can be offset by the gains from another investment.
Hedging: a strategy of using derivatives, such as options, futures, swaps, etc., to reduce or eliminate exposure to a certain risk factor or to lock in a certain return. Hedging works by creating an opposite or offsetting position in the derivative market that counterbalances the position in the underlying market. For example, an investor who owns a stock can hedge against the downside risk by buying a put option on the same stock, which gives them the right to sell the stock at a predetermined price.
Conclusion
Compounding is one of the most powerful concepts in finance that can help you multiply your money exponentially over time. Mutual funds are a great way to leverage the power of compounding, as they offer diversified, professionally managed, and tax-efficient investment options. However, to benefit from the magic of compounding in mutual funds, you need to choose the right schemes, invest early and regularly, stay invested for the long term, and review your portfolio periodically. By following these tips, you can create wealth and achieve your financial goals with the help of mutual funds.
FAQs
Q: How much return has the fund given in the past 5 years and 10 years?
Ans. According to the data from Value Research, the Nippon India Growth Fund has given a compounded annual growth rate (CAGR) of 25.72% in the past 5 years and 19.82% in the past 10 years, as of February 19, 2024.
Q: How much would ₹1 lakh invested in the fund 10 years ago be worth today?
Q: What are the tips to harness the power of compounding for financial goals?
Ans. The tips to harness the power of compounding for financial goals are:
Choose the right mutual fund scheme that matches your risk appetite, investment horizon, and financial goals.
Start investing early and regularly.
Stay invested for the long term and avoid frequent withdrawals or switches.
Review your portfolio periodically and rebalance if needed.
