How Compounding Works in Mutual Funds

We, as humans, work hard to earn money to meet our basic requirements and to make our living better. We tend to accumulate various assets to feel secure as well as to grow our wealth. Did we ever wonder that there is someone who can work as hard as us (or even harder) to earn money for us? It is actually our own money!!

Famous quote by Einstein- “Compounding is the 8th wonder of the world” is indeed true when it comes to long term investing. An investment of Rs. 1 lac doubles to 2 lacs in 5 years but grows to 16 lacs i.e. 16 times in 20 years @15% rate of return.

Before we discuss how compounding happens in mutual funds, let’s first see how compounding itself works.

How does Compounding happen

Compounding is earning interest on interest or having further growth on growth. If one does not withdraw gains from investments, then subsequent year gain comes on the entire amount i.e. amount invested plus the gains on the original investment, not just on principal amount. Longer the time duration, higher would be the gains and this eventually leads to much higher fund value at the end of the investment horizon.

Compounding in Mutual Funds

In the above example, the rate of interest has been assumed as fixed and is known when the investment is made. This type of example of compounding perfectly fits and is applicable to guaranteed income products like fixed deposits, bonds, NSCs, term deposits etc.

However, the mutual fund investments are market linked and their growth/rate of return is not guaranteed. Therefore, the compounding in mutual funds works in a slightly different manner. In Mutual Funds when we talk about returns, it is actually a growth on growth(and not interest on interest), which when converted into percentage give us compounded rate of return.

Why it is different in mutual funds?

When we invest an amount in a mutual fund scheme, units of that scheme are allotted at a unit rate called NAV (or we can say purchase price per unit) on that day. The total value of units allotted are same as the amount of investment.

The mutual fund schemes invest in certain stocks or securities, the total value of which changes everyday with the change in price of those investments. With the change in value of these investments, NAV of that particular scheme changes every day. Increase or decrease in value of these investments leads to rise or fall in NAV on a daily basis. However, over a longer period, as the values of investments grow, the NAV also grows.

Conclusion:

Compounding has a power to multiply investment to the extent that it crosses the point where our gains are more than the principal amount invested. Starting early and sticking to an investment while giving it an ample time to grow is key to wealth creation. The power of compounding makes many impossible looking financial goals possible. Make it your best friend and you may never be in a need of another(financial) one.

We wish you Happy Investing!