Power of Compounding and Mutual Funds

At sometime or the other, we all have heard about how compounding plays a significant role in savings and investments. The concept of compounding is quite simple – amount put into an interest earning instrument, earns interest over one cycle, and in the next cycle, interest earned is added to the original amount and together they earn interest. This cycle goes on through the period of the savings or investments.

Compound interestis different from simple interest and we can bestunderstand this with a simple example, whereone invests ₹1,000 earning 5% annually for 30 years. With simple interest at the end of 30 years, ₹1,000will earn ₹1,500. However, with compound interest, the ₹50 earned in the first year is added to the original investment in the second year. Thus the interest earned in the second year is ₹1,050 times 5%, or ₹52.50. This is then added to ₹1,050 for the third year, and so on.

By the end of the 30th year total earnings are ₹3,322. This is ₹1,822 more compared to the simple interest calculation; whichmay seem magical, but is a simple mathematical law. In effect, compounding earns a passive stream over time, which in the long run can add up to a considerable amount.

SIP and Compounding

A Systematic Investment Plan (or SIP) is an investment mode through which one can invest in mutual funds periodically, which could be weekly, monthly, quarterly, semi- annually or annually. When you invest steadily in this manner, it can become easier to meet your financial goals. By taking the SIP route for investments, you could invest for a defined time period without worrying about the market dynamics and have the chance to benefit in the long term as you average the cost of investments and the power of compounding.

When you invest regularly through SIPs for the long term, the benefits could magnify by the compounding effect. Compounding in case of SIPs is the ability of the fund to generate earnings, which are then reinvested or remain invested with the goal of generating their own earnings. In this case, you do not earn an interest, you earn potential returns, but please note that these are not guaranteed and are based on the market conditions. For compounding to play its role, you need to stay invested in the fund over a long period of time for the returns to compound over time.

Let us take the case of investing for 30 years in three different investment options that earn 8%, 12% and 15% returns respectively. Now, if one had invested ₹5,000 through monthly SIPs, the cumulative investments would add up to ₹18 lakh. The power of compounding plays a significant role here. Your investment of ₹18 lakhs would grow up to ₹75 lakhs over 30 years assuming your investment earns 8% returns, ₹1.75 crore assuming your investment earns 12%. and ₹3.5 crore assuming your investment earns 15% (See: Power of Compounding). It is not just SIPs where the gains are significant because of compounding, even in cases where a lump sum investment is made; the value of investment could go up significantly over time. For instance, if one had invested ₹118 in the S&P BSE Sensex in Jan 1981, when the index was 118, the worth of that ₹118 on Jan 1, 2021 would be ₹47,868, which is a compounded annual growth rate of 16.19% (Source: S&P BSE Sensex Historical data and internal calculations). For investments to benefit from compounding, time is crucial and the longer the investment time frame, the better the chances of compounding playing its role.

Over a period of ten years from Jan 1, 2011 to May 1, 2021, SIP investments of ₹1,000 were considered (See: Compounding at work). Over this period the markets went down and up and along with it investments also remained volatile. That is what investors need to know about mutual fund investing that unlike a fixed return financial instrument, compounding in case of mutual fund investments do not follow a straight line growth. There are phases when SIP investments may also face negative returns; investors who have tracked the S&P BSE Sensex for long may recollect how the index had witnessed a 50% drop in 2008-9. What compounding does over the long period is build wealth.

Compounding and Financial goals

Over the years, SIPs have become a convenient tool to achieve financial goals for the flexibility they offer on the amount one wishes to invest and the time for which one wishes to invest. SIPs also help in effective planning of different financial goals at the same time through regular investments, providing investors with a clear regular investment needed for each goal and the progress made by the investments towards each goal over time.

Long term goals include creating a retirement corpus or savings towards children’s education, whereas short and medium term goals could be savings towards a vacation or down payment of a house among other goals. Investing through SIPs in equity- oriented mutual funds is suited for long-term goals, whereas debt funds are suitable for shorter-term goals. For instance, an investor starts investing ₹5,000 through a monthly SIP in the S&P BSE Sensex from January 2011 till May 2021, the cumulative investment of ₹6.25 lakh over this period would be worth ₹12.45 lakh at 12.57% XIRR (Extended Internal Rate of Return), which is the single rate of return, which when applied to every SIP instalment (and redemptions if any) would give the current value of the total investment. (Source: S&P BSE Sensex Historical data and internal calculations). The combination of averaging and compounding is a powerful tool when investing in the long run.

Now, if the same investor had a short-term goal of 18 months with the choice to park money in a bank recurring deposit earning 5% or a Liquid fund represented by the S&P BSE Liquid Rate Index (See: Short-term compounding). Compounding works for shorter durations as well and mutual fund investments do score on tax efficiency if the investments are planned in suitable mutual fund schemes with appropriate investment time frame.

Time is on Your Side

Compounding works well in the long run and can be understood by the difference it can make to investments, especially when one starts investing early and has a much longer time frame to invest. For instance, three friends start investing ₹5,000 in an instrument earning 10% returns till age 60. However, one starts investing this sum on turning 25, the second starts to invest from age 30 and the last from age 35. One may think a delay of 5 years may not play a big role; however, it does (See: Power of Early Start).

In the above example, if C had started to invest ₹10,000 instead of ₹5,000 to catch on the late start at the same 10% returns; at age 60 the cumulative investments in this case would be ₹30 lakh and it would be worth ₹1.33 crore. It would be still short by ₹58 lakh of what A manages to accumulate with cumulative ₹21 lakh investment over 35 years. Clearly, investing early could be important to benefit from the magic of compounding. It’s important to start investing early and it can’t be stressed enough.

Flexibility with compounding

Ideally how much one invests changes with changing circumstances and financial goals – investors increase SIP contributions with increase in salary or with increase in financial goal. As SIP contributions can be increased automatically through SIP booster or top-up feature, wherein the SIP investment goes up by a fixed percentage generally each passing year. This feature can be beneficial with compounding (See: Incremental SIP and compounding). Investor A starts a monthly SIP of ₹5,000 for 25 years and Investor B starts the same amount, but each year Investor B does a top- up of SIP by 10%, so, in year 2 the SIP becomes ₹5,500 and so on. The power of compounding effect benefits from the long-term of investment as well as the incremental investments each passing year.

For compounding to work, it requires three things – regular investments, long investment tenure and frequent investments. The longer the investment period, the more the interest on interest earned and hence you have time working to your advantage. Likewise, it is ideal to save steadily through your working years to reap maximum benefits. The more frequent the interval of compounding, the greater is the impact of compounding. For instance, value of ₹1,000 at 8% interest works to ₹1,080 or ₹1,083 when compounded monthly. This mathematical fact could be used to benefit one’s investment through more frequent investments in the long run.

However, compound interest is also often misunderstood, especially when investing in mutual funds, as unlike a linear growth in case of fixed return instruments, the path taken by mutual fund investments aren’t linear. Albert Einstein was reportedly quoted as stating that compound interest is the most powerful force in the universe. All you need is to start investing, for each day you wait is a day you miss out on the opportunity to compound.