Mutual Funds: Your Gateway To Compounding Success

Most of us start striving for success and wealth very early on. We study diligently to get good grades, enroll into prestigious schools, opt for lucrative careers and work hard at our jobs. As you do everything to make it in this big bad world, you don’t want to miss out an underrated and potent tool to create long term wealth - the power of compounding.

The power of compounding works when you not only earn income on the principal amount but also on the income that has already been earned. This is done by reinvesting the earned income instead of withdrawing it.

For example, if you earn 20% return on a principal of Rs 100, at the end of 1 year you would make Rs 20. If you choose to withdraw this Rs 20, only the original Rs 100 will be invested for the second year, earning Rs 20 again. Over a period of 10 years, this process of withdrawing gains and only letting the initial capital grow would create Rs 200 for you, bringing your total wealth to Rs 300, including the Rs 100 originally invested.

Instead, if you let the Rs 20 stay invested along with the principal of Rs 100, next year you stand to earn Rs 24 as the 20% return will now be generated on Rs 120 instead of just Rs 100. Over a period of 10 years, this process of reinvesting gains would create Rs 519 for you, bringing your total wealth to Rs 619, including the Rs 100 originally invested.

Power of compounding thus lets your money make more money. To benefit from compounding, you don’t need to have a big bank balance or be an investment expert. One of the most simple and convenient ways for a layman to take advantage of this financial phenomenon is through mutual funds. Mutual funds are investment vehicles which enable investors to outsource their capital market investments to professional fund managers for a small fee. The assets and securities to invest in are selected by the fund managers after rigorous research. These assets generate returns in the form of interest, dividends or capital gains. If reinvested, these can be used by the mutual fund to buy more of the underlying securities, allowing you to make money on the original sum invested as well as the subsequent earnings.

Instead of waiting to accumulate a lumpsum amount, investors can also opt for Systematic Investments Plans or SIPS which let you invest fixed amounts of money in mutual funds at regular intervals. These too can be used to benefit from compounding. Earlier instalments of SIP enjoy an extended investment horizon letting that money compound for longer. SIPs also ensure the investor regularly contributes to the principal amount, increasing it and amplifying the compounding process.

Mutual funds are a preferred way to compound and grow wealth as they have transparent processes and are well regulated. Being research-backed and professionally managed, mutual funds can help investors invest in the right investments, potentially augmenting the compounding of returns. Mutual funds enable one to get exposure to a larger range of securities with lower capital, effectively reducing risk. They are also very easily and quickly liquidated. To maximise compounding in mutual funds, it is important to start early and stay invested for the long term.

Disclaimer: The Views are Personal and not a part of the Outlook Money Editorial Feature