Compounding growth is a fantastic thing when it comes to mutual funds and investments; but it can be found everywhere! You and I started as embryos but we are finally here because those embryonic cell grew at rapid pace! Behind all life forms there is a simple math. This math has compounding at its core.
Remember the story where a king generously offered a man anything he asked. The man said he just need two grains of rice for each of the 64 squares on a chessboard. The condition was that number of grains would be double of the previous square. In the end the king had to sell his entire kingdom!
Compounding has been called the Eighth Wonder of the world! Why? Read on..
What is Compounding Interest & Growth?
It is simply interest earned on the interest generated by the original investment.
(Did you see a simpler definition? 🙂 )
How does Compounding Work in Mutual Funds?
Let’s take an example right away. Suppose Ram invests Rs 1,00,000 every year from age of 25 up to his retirement at age 58. He would have invested Rs 34,00,000. Simple interest on this would be Rs 3,40,000. A total of Rs 37,40,000. Cool isn’t it?
NO! compare this compounding. Had he earned interest on the interest every year, ie interest on Rs 1,10,000 in the second year (because his first year end balance would be Rs 10% on 100,000 + Rs 1,00,000 = Rs 1,10,000) and so on, then he will have a larger kitty.
How much? That is Rs 2.7 crores! SEVEN times more when compared to original + simple interest. If you don’t include the simple interest, then its EIGHT time more than the original investment.
|Age||Ram Starts at age 25|
What is the impact of starting early in mutual fund investments?
Starting early is important simply because your base grows larger with time. Let’s take a second example.
Suppose Ram’s twin brother Shyam also starts investing Rs 1,00,000 every year until his retirement at age 58. The difference is that he starts at age 35, which is 10 years after Shyam.
Only 10 years later, what difference does it really make? The table bellows that while Ram ends up with Rs 2.7 crores, Shyam ends up with only Rs 97 lakhs!
Here are the highlights:
- Ram gets EIGHT times his original investment.
- Shyam gets only FOUR times his original investment because he did not start early.
- Just by starting earlier Ram makes THREE times more money than Shyam investing the same Rs 1,00,000 every year.
And the numbers below:
|Age||Ram Starts at age 25||Shyam Starts at age 35|
Why is this so important? Because of Inflation!
While compounding is your Brahmastra or divine weapon acting FOR you, inflation is the opposite, working against you.
An inflation of 8% makes an original amount of Rs 1 lakh reduces to HALF in eight years. The average inflation for the last eight years has actually been 8%.
Unless your money works for you day and night (yes it works at night also), inflation will eat half of it in 8 years.
|Amount after Inflation|
The Danger of Compounding Commissions in Mutual Funds
Just like those seemingly small things like starting early, or inflation there is another hurdle to your financial well-being. This is compounding commissions of Rs 1% to 1.5% on your investment every years.
Let’s take another example. Suppose Ram had invested through a commission-based advisor (93% of people do that). The advisor could be a person or a portal like ICICI Direct, ET Money, Scripbox, Funds India etc. Commission taken is only 1% per year.
Ram’s money instead of giving him Rs 2.7 crores will give him just Rs 2.1 crores. In other words, compared to 2.1 cores, he would have earned 33% more in 20 years by going 0% commission.
|Age||With 1% commission||With 0% commission|
The actual commissions are more (depending on the fund). With a commission of 1.5% the corpus reduces to Rs 1.9 crores. Going direct he could have made 40% more!
Bonus Tip 1: Should I opt for Growth or Dividend option in Mutual Funds (all this compounding!)
For mutual fund investors, a common choice is to invest in Growth Option or Dividend Option. The difference is that in Dividend Option the gains are given back to the investor regularly; in Growth option, they are reinvested in the same fund for more growth.
If you are smart investor focused on the long term, you know the answer! Go for the Growth option as that allows you to compound your money much more over the years!
Bonus Tip 2: Avoid Debt
With Debt, compounding is working AGAINST you! Imagine Ram climbing a mountain up, whereas Shyam is sliding backward. That is debt for you.
Conclusion & Summary:
With the FOUR simple examples above, we all agree that:
- Start really early, a small amount like Rs 1000 is absolutely fine!
- Beat the evil of inflation with compounding
- With mutual funds invest in Direct Plans only, even 1% lesser return means you can lose ONE-THIRD of potential gains. Or upto 40%
- Opt for Growth options of mutual funds if you are looking for higher value creation in the long term.
Even Albert Einstein noted that “He who understands compounding, earns it but he who doesn’t pay it.”