How Compounding works in Mutual Funds

If your money is not working hard 24/7 for you then you will always end up working hard for your money till your last breath.

Compounding does that for you, it works for you even when you are not working.

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What is compounding?

Compounding is magical and yet simple & effective all at the same time.

Compounding by definition means the increase in value of an investment because of the gains earned not only on the principal amount but also the interest amount.

Simple interest refers to the interest gained on an investment whereas compound interest refers to the gains on both the principal as well as the interest.

In simple language, with compounding you can gain not only on the principal amount but also the interest amount.


Additional reading: Click Here to read about how Inflation is destroying your hard earned money.

Benefits of compounding

In compounding, the interest earned is reinvested.

Therefore both your principal amount as well as your interest amount is both always at work.

In a year or two it may not amount to much but the real benefit of this can be seen only after a few years.

Therefore this is a very powerful tool for long term goals since compounding in the long run has the potential to beat inflation.


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SIP’s and Compounding

For compounding to be really effective, the two most important points to consider are time & reinvestment of earnings.

As mentioned previously, compounding needs time to work its magic and is not a short term solution.

Imagine a system where not only are you able to generate returns on your principal amount but also your earnings.

SIP in a mutual fund is built in a manner very conducive to this, the only thing you need to do is absolutely nothing.

The amount no matter how small will be debited on a monthly basis over a long period of time, irrespective of market highs or lows and thereby your investments get averaged out and volatility takes a backseat.

With the growth plan, your earnings stay invested and can fetch returns too and therefore using this process can build wealth in the long run.

Stopping sip’s in between or withdrawing any amount is detrimental to the overall process though.

No matter how small the amount, just begin because a difference of even 5 years can make a huge difference in the end.

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This is because in those 5 years, the principal amount as well as the returns on the principal amount generated gains.


Features of Compounding in SIP mutual fund


Stay disciplined no matter what.

Do not let the market highs & lows deter you in any manner whatsoever.

Do not fall into the trap of stopping your sips during market lows and letting fear win, this is counter productive.

Make sure you do not miss any sip installment.


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Start early

Start as early as possible irrespective of how small your amount may be.

It is better to start early with a small amount than to start later with a higher amount.

This is because when you start off with a smaller amount, you are giving it time to grow.

This means not only your principal amount but also your earnings are working for you and fetching returns.

Time is of essence here, you can start off later with a higher amount but you will never be able to make up for lost time and the more time you spend in the market, the better it is for your portfolio.


Additional reading: Click Here to read about some common myths & facts about mutual funds

Keep growing

As you progress in your career, so should your allocation to sips.

Do not stick still with the amount you began with.

Remember, inflation is going to keep on growing so you need to increase your allocation.

Control your expenses and let your needs take precedence over your wants.


Learn patience

Patience as a virtue cannot be taught, it can only be learnt.

Sadly even today many investors try chasing quick returns.

They end up making losses and then in order to recuperate those losses, make more losses.

It’s a vicious circle.

There is no short cut to building wealth via investing in mutual funds, you have to take the long route.

The easiest way to go about this is to link your investments to long term goals so you are not tempted to move out quickly and stay motivated by your long term goals.


Avoid outside noise

It is in human nature to be influenced by others.

Often investors are lured and swayed by those who claim to have tips and knowledge of best funds.

Media outlets often resort to panic driven headlines motivated by driving in more clicks.

Then of course there’s our friends, family and relatives with their mandatory but unsolicited advice on what we are doing wrong.

Yet with everything said & done, can anyone of those mentioned above take accountability for their advice?

Think of it in this way, would you get a medical operation done by someone who’s qualified and a professional or someone you just happen to know.

Often when one takes any advice from someone with no accountability, not only is future returns at risk but whatever has been accumulated so far also becomes prone to downfall.

Compounding is the most effective & yet the simplest point of investing in mutual funds and turning your money into wealth.

Where most people unfortunately falter is at not having enough patience & being unable to stay the course.

Let your money work for you rather than you working hard for it.   

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Disclaimer : While due precaution has been undertaken in the preparation of this article, The Mutual Fund Guide or any of its authors will not be held liable for any investments based on the above article. The above article should not be considered financial advice and has been published only for your perusal. Due credit has been given in case wherever required, in case you feel any part violates any rights then do get in touch with us and we shall get it duly removed.  
Mutual Fund investments are subject to market risks. Please read the offer document carefully before investing

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