How Does Compounding Work In Mutual Funds?
Compounding basically means earning interest on interest. Mutual funds are marketable securities, and their returns depend on market movements. They don’t give a fixed interest to investors. Then why do people say the power of compounding in mutual funds helps you grow wealth in the long term? Do mutual funds give compound interest? Read to find out about compounding in mutual funds.
Mutual fund returns
Before understanding compounding in mutual funds, we need to understand mutual fund returns. While there are various types of mutual fund returns, the following two are the most commonly used.
Absolute returns
Remember calculating profit from selling price and cost price in class 6 math? Absolute returns are basically the profit you make on selling goods. It is simple to calculate and tells by how much your investment has grown, irrespective of the time period.
Absolute return = ((Final value – initial investment)/(Initial investment))*100
Absolute returns don’t change irrespective of the time period. Hence it gets difficult to compare the absolute returns of two investments.
Let’s understand this with an example. Suppose you invest Rs 10,000 in two funds, Fund A and Fund B. Fund A grows to Rs 15,000 in 3 years, and Fund B grows to Rs 18,000 in 5 years. The return from Fund A and Fund B is 50% and 80%, respectively. Fund B gave you good returns, but it took five years, and Fund A gave you a 50% return in just three years. You cannot compare these two funds because you don’t know which fund made you better returns in a short period.
This is where the annualized return comes into the picture. The limitations of absolute returns are taken care of by annualized returns.
Annualized Returns or Compound Annual Growth Rate (CAGR)
Annualized return or CAGR is the average return you earn per annum. It gives you a snapshot of the fund’s performance over a period of time, making it easy to compare the performance of two funds.
Annualized return = ((1+absolute return)^(1/n))-1
where n is the number of years.
In the above example, Fund A’s annualized return is 14.47%, whereas Fund B’s return is 12.47%. This means Fund A gave an average return of 14.47% every year for three years, and Fund B gave 12.47% every year for five years.
Fund A has performed better than Fund B. If you had stayed invested in Fund A for two more years, you would’ve made Rs 19,655, which is higher by Rs 1,655 than Fund B.
If you stayed invested in these two funds for seven and ten years, your returns would look something like this.
| Investment Duration | Fund A | Fund B |
| Five years | Rs 19,654 | Rs 18,000 |
| Seven years | Rs 25,754 | Rs 22,764 |
| Ten years | Rs 38,629 | Rs 32,387 |
The above table shows that the longer the investment duration, the higher the return. The returns have multiplied over the years, just like earning compound interest. Compounding works best in the long term.
What does compounding mean?
Compounding is a process where principal and interest earn interest. In other words, it simply means the interest on interest. The compounding period can be daily, monthly, half-yearly, or annually. The higher the compounding periods, the higher the value of the investment. Therefore, an investment with two compounding periods a year is better than one, and four compounding periods are better than two.
However, when it comes to a loan, lower compounding periods are better because the unpaid principal and interest amount are charged interest, increasing the amount you owe quickly.
To calculate the future value of an investment using compound interest, the following formula can be used.
Future value = Present value * (1+i/n)^ nt
Where i is the interest rate per annum
n is the number of compounding periods
t is the duration
Compounding in Mutual Funds
Mutual funds don’t pay a fixed interest. However, there are three ways in which you can make money from mutual funds. First is through dividends that the fund pays, second is through the capital gains fund managers distribute, and last is when you sell your mutual fund units.
In mutual funds, you can grow your money quickly through compounding even though you don’t earn a fixed interest.
But how’s that possible? How does compounding work in mutual funds?
When you invest in mutual funds through a Systematic Investment Plan (SIP), you invest regularly. The more you invest and the longer you stay invested, the more your money grows. In case you reinvest the dividend, the chances of you growing your money increase. This is because you are purchasing additional units that add to the already accumulated units, making your money grow faster.
Let’s understand this with an example.
Example
Anita and Deepa invest Rs 5,000 and Rs 12,000, respectively, in mutual funds through SIP. Anita starts investing at the age of 25, Deepa starts at the age of 40, and they keep investing until the age of 60. If both earn a similar return of 14% from their investment, who do you think will be richer by the age of 60?
The total investment for Anita is 21 lakhs in 35 years, which will have grown to Rs 5.61 crore. In the case of Deepa, for a total investment of Rs 28.8 lakhs in 20 years, she would’ve made Rs 1.57 crore.
Why is there a lot of difference between the two? Why is Anita richer than Deepa?
Clearly, it is the magic of compounding. Despite investing less amount, Anita has accumulated almost 3.5 times more wealth than Deepa. This is because of the investment duration. Anita invested for 35 years, whereas Deepa invested only for 20 years. The returns have multiplied (compounded) over the years. This clearly shows that compounding works best in the long-term horizon. The longer the investment horizon, the greater would be the gains.
Hence you should take advantage of compounding by starting your investments at an early age. If you didn’t, then no problem, start your investments today. Better late than never, right?
Power of compounding
Compounding is an investing strategy to make your money work for you. You earn interest on the principal and interest, which accumulates over time and grows through a snowball effect. Through the power of compounding, you can grow your wealth and achieve all your financial goals.
The power of compounding has several benefits, and below are some of them.
- Wealth accumulation: You can accumulate huge wealth over time through compounding. Since the returns are multiplied over time, the longer you stay invested, the higher your maturity corpus.
- Bridging shortfall in the corpus: With the power of compounding, you can bridge the gap in your target amount. It’s due to compounding that you are able to meet your goals.
- Balancing the inflation: Mutual funds give inflation-beating returns. That’s possible only due to compounding. When inflation erodes the wealth you’ve earned, compounding balances it by growing your money over time.
Rules of Power of Compounding
To maximize the benefits of the power of compounding, you have to follow certain rules.
- Start early: You can accumulate more wealth by investing at a young age. You should start investing right from the time you start earning. But if you didn’t, then now is the right time to invest. Plan your financial goals and start investing in mutual funds today.
- Be consistent: Consistency is the key to financial success. Make sure you set aside at least 20% of your monthly income for investments. Automate your investments to inculcate financial discipline.
- Step up your investment: As you grow in your career, your income will also increase, and so will your expenses. Hence you have to increase your investments every year. This will help you reach your goals sooner than you planned and also help in beating inflation.
- Practice patience: Mutual funds are marketable securities and are volatile in the short term. Don’t get disheartened when you see your portfolio red. Don’t look for short-term gains, as you might end up making huge losses. Be patient and stay invested until you reach your goal. However, you have to keep monitoring your portfolio every now and then.
Difference between CAGR and Compound interest
Compound interest is earning interest on the principal and accumulated interest. Your returns are multiplied over the years due to compounding. Compound interest tells what rate of interest you will earn for a given period.
Conversely, a CAGR tells by how much your investment grows every year over a period of time. It is the average rate of return you will earn per annum for a given period. It is calculated based on historical data and helps you estimate future returns.
Calculators for compounding
Though interest calculation is easy, there are many tools that will help you estimate the returns you will earn from your investments. One such tool is Jupiter’s interest calculator.
The calculator helps estimate both simple and compound interest. For estimating the return using simple interest, the calculator asks for the investment amount, duration, and interest rate. Based on your inputs, it will calculate the interest and maturity amount.
The compound interest calculator requires you to give the number of compounding periods apart from the interest rate, amount, and duration. Again, based on your inputs, it gives the result, which includes interest and maturity amount.
Using Jupiter’s interest calculator, you can plan your goals and compare investments by calculating the maturity amount you will receive in the future.
Frequently Asked Questions
Does Mutual Funds SIP give compound interest?
Mutual funds do not give a fixed interest. They are marketable securities, and their returns vary based on market movements. However, you can grow your money over a period of time through compounding. Historically, mutual funds have given good returns in the long term. You can accumulate wealth through compounding by staying invested in mutual funds for the long term.
Is compound interest good for short-term investors?
Compounding works well in the long term. To maximize your returns through compounding, you have to stay invested for the long term. Hence this strategy will not be the best for short-term investors.
Do any investment compounds daily?
Some banks compound interest daily on a savings account. But apart from this, no other investment compounds interest daily.
Is SIP compounded monthly or annually?
SIP in mutual funds allows you to invest money every month. But that doesn’t mean you can compound monthly or annually through SIP. Since you invest for the long term, the money multiplies faster through compounding. However, there is no set compounding period for SIP.
Is mutual funds’ interest compounded monthly or yearly?
Mutual funds do not pay any interest and are certainly not compounded monthly or yearly. Your money will grow over time if you stay invested for long durations. This effect is called compounding, as your investment multiplies over time.
