Everyone has studied compound interest in school but how many of us know how compounding works in our investments? Compounding helps you grow your money exponentially over the long term. Mutual funds are the most popular instrument where the power of compounding helps in wealth creation. A SIP calculator is a good way to understand how compounding works in your SIP investments.
What is the power of compounding?
The power of compounding is nothing but the concept of compound interest working on your money. Compound interest is the interest on an investment or deposit which is calculated on the principal amount as well as on the interest earned over time. Mathematically, the compound interest is calculated using the following formula,
A = P(1+r/n) Λ (nt)
Where,
A = Future value of the investment
r = annual rate of return
n = number of time interest is compounded in a year, also known as compounding frequency
t = investment tenure
Compounding is reinvesting the interest you earn on your investments. As a result, the principal amount keeps growing every year and the returns are earned not only on the principal amount but also on the previously accrued returns. The power of compounding accelerates the process of wealth creation.
For instance, you invest ₹ 50,000 in an instrument with a return of 10% for 5 years and you decide to reinvest the interest earned annually. So after the first year, the interest amount of ₹ 5000 will be added to the principal amount and now the interest will be calculated on ₹ 55,000 as illustrated in the table below;
Compounding in SIP investments
A Systematic Investment Plan (SIP) is a small predefined investment in a mutual fund scheme. The power of compounding in SIP investments is based on the idea of earning interest on interest. The interest you earn is reinvested in the same scheme increasing the value of your investment. These small regular investments can help you make a corpus with compounding.
An online SIP calculator can help you calculate the expected returns on your SIP investments for an investment tenure. To get the maximum benefit of compounding, follow the tips given below.
1. Start early
Start your investment journey at a young age to increase your investment horizon. Time impacts compound interest calculations hence a long investment tenure increases the compounding effect. If you start investing as soon as you start earning your investments get a long time to grow and you can build a significant corpus by the time you retire.
2. Stay Consistent
Invest regularly without any gaps to get the continuous benefit of compounding. Develop a habit of keeping money aside for your investments every month irrespective of your earnings.
3. Reinvest returns
Compounding works when you reinvest the earnings from your mutual fund scheme instead of withdrawing. It increases your returns by adding the interest back to the principal amount.
4. Compounding frequency
Compounding gives better returns with more compounding periods. This is why monthly SIPs give better returns because compounding monthly can earn more than compounding annually.
5. Select mutual funds with good returns
The asset you select also increases the effect of compounding. Mutual fund schemes with growth potential can give you good returns in the long term. Do your research and analyse different schemes before investing.
Conclusion
With compounding an investor can achieve his long-term financial goals using regular SIP investments. Periodically increasing SIP investments can further enhance the compounding effect and give you increased returns. To get an estimate of how much to invest and for how long use a SIP calculator and achieve your financial goals.