Mutual funds are often considered the best investment option. Besides high returns and diversification of investment, mutual funds are an attractive and wise investment choice among investors due to the power of compounding.
What is Compounding in Mutual Funds?
Mutual Funds provide 2 types of earnings- Dividends and Capital Gains. If instead of withdrawing, you keep your earnings invested in a mutual fund scheme, you benefit from compounding. Compounding basically means that you earn returns not only on your principal investment but also on the returns generated by that investment.
How Does Power of Compounding Work?
Due to the effect of compounding, investors earn returns from both their initial principal investment as well as the accumulated returns generated by the initial investment over successive periods.
Let’s understand this better with the help of an example. Suppose both Mr. A and Mr. B invest Rs. 50,000 each in ICICI Prudential Bluechip Fund- Direct Plan (growth option) on August 14, 2014, for 5 years.
While Mr. A keeps his earnings invested in the mutual fund scheme, Mr. B opts to withdraw the earnings annually. The ICICI Prudential Bluechip Fund has given an annualized return of 10.24% over the last 5 years period (as on August 14, 2019). The below table illustrates the returns earned by both Mr. A and Mr. B on their investment.
| Mr. A | Mr. B | |||||
| Investment Year | Investment Value at the beginning of the year (Rs.) | Withdrawal Amount (Rs.) | Year-end Value of Investment (Rs.) | Investment Value at the beginning of the year (Rs.) | Withdrawal Amount (Rs.) | Year-end Value of Investment (Rs.) |
| 2014 | 50,000 | 0 | 55,120 | 50,000 | 0 | 55,120 |
| 2015 | 55,120 | 0 | 60,764 | 50,000 | 5,120 | 55,120 |
| 2016 | 60,764 | 0 | 66,986 | 50,000 | 5,120 | 55,120 |
| 2017 | 66,986 | 0 | 73,845 | 50,000 | 5,120 | 55,120 |
| 2018 | 73,845 | 0 | 81,406 | 50,000 | 5,120 | 55,120 |
| Earnings | 31,406 | 25,600 | ||||
Thus, Mr. A earns Rs. 5,806 more than Mr. B over the same investment amount invested for the same number of years, due to compounding.
This is how the power of compounding helps you in multiplying your money in mutual funds. You can read about the top 5 mutual fund schemes for 2019 here.
How To Make The Most of Power of Compounding?
As an investor, you can inculcate the following financial habits in your financial decisions to benefit from your mutual fund investment via the power of compounding:
- Start Investing Early
The earlier you start investing, the better it is as it allows you to have a longer investment horizon. Longer the investment horizon, greater the probability of earning higher returns as investment risk gets reduced over longer time periods. So, in order to make the most of the power of compounding from your mutual fund investments, start investing as early as you can. If you have not started yet, start investing now!
- Be a Disciplined Investor
Being a disciplined investor means investing regularly and monitoring it periodically. Investors should avoid ad hoc and abrupt investment decisions and follow a proactive and well thought out investment strategy.
- Be A Patient Investor
Patience and investing go hand in hand. In order to earn good returns, an investor must stay patient and not act in an impulsive manner, reacting to every sudden stock market movement. This becomes more important for long-term investments when abrupt stock market movements are more in number and triggering in nature.
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