India's mutual fund industry has been making the news for all the right reasons. The total assets under management (AUM) grew from ₹10.83 trillion¹ on March 31, 2015 to ₹65.74 trillion on March 31, 2025. This marks a 6x increase in just 10 years!
The numbers may be proof that Indians are turning to long-term investing to build wealth. But market rallies alone do not explain this growth. The real reason smart investors are choosing mutual funds is compounding: a force that quietly turns time into money.
Not sure what compounding is? You’re not alone. Many beginner investors are not aware of this concept and how it can benefit them significantly if they use it right. This is where we come in. Let’s walk you through what compounding is, how it works and how you can make the most of the power of compounding in mutual funds.
What is Compounding?
Compounding is a phenomenon where you earn returns on your returns reinvested. This occurs because any interest that you earn from an investment is reinvested in that asset or scheme. So, that interest generates additional returns over the next period, leading to an exponential rather than a linear increase in your returns.
To further understand what compounding is, you must compare it with simple interest, which is the most basic form of earning returns on an asset. Here, only the value of the asset or the principal invested earns returns during the investment period. So, if the rate of returns is fixed, you will continue to earn the same amount in each period.
In compound interest, however, the returns you earn in the first period are reinvested. So, in the second cycle, you earn returns on a higher amount. Assuming the rate of returns remains unchanged, you will continue to earn a higher amount in each period. This forms the basis of the power of compounding for investors.
How Compounding Works: A Simple Example
If you need more clarity on what compounding is, an example can help. Let us discuss a hypothetical scenario to delve deeper into how this financial principle works.
Assume you invest ₹1 lakh in an investment scheme at 10% per annum. Here’s how your investment grows with compounding:
| Year | Opening Amount (₹) | Interest Earned (₹) | Closing Amount (₹) |
| 1 | 1,00,000 | 10,000 | 1,10,000 |
| 2 | 1,10,000 | 11,000 | 1,21,000 |
| 3 | 1,21,000 | 12,100 | 1,33,100 |
| 4 | 1,33,100 | 13,310 | 1,46,410 |
| 5 | 1,46,410 | 14,641 | 1,61,051 |
This is how the power of compounding can exponentially increase your potential returns over time. You can earn passively by simply choosing a suitable investment option like a mutual fund, which helps you tap into the advantages of compounding easily.
Decoding the Compounding Formula
As you may have gathered from the discussion of what compounding is, it is essentially a mathematical concept. So, it is easy to compute the compounded returns from an investment if you know a few crucial parameters and understand the mathematical formula involved.
This is the formula you can use to compute the compound interest from an asset:
CI = P [(1 + r/n)nt − 1]
In this formula:
- ‘CI’ is the compound interest or the compounded returns
- ‘P’ is the initial amount you invest in the asset or scheme
- ‘r’ is the rate of compounding per annum (used as a decimal)
- ‘n’ is how many times in a year the returns are compounded
- ‘t’ is the duration of investment (used in years)
Compounding in Mutual Funds
Mutual funds invest in a wide range of assets from different asset classes, depending on the type of fund you choose. The power of compounding can be observed in mutual funds that distribute dividends to investors.
Compounding in mutual funds comes into play when you reinvest the returns earned on your original investment, so the future returns are calculated on a growing corpus. When you stay invested over time, your returns, whether from capital appreciation or dividend reinvestment, can generate their own returns. This cycle of earning on both the principal and the past earnings can accelerate the process of wealth creation.
Why Time Matters for Compounding in Mutual Funds
When it comes to decoding what compounding is and how you can use it to your advantage, you need to remember that time is of the essence here. Check out the key reasons time is crucial for compounding.
- It Positively Impacts Compounding
In the formula for compounding, time plays a key role. It is expressed as the exponent, meaning that the longer the investment period, the greater the exponential growth may be.
- It Offers the Potential for Long-Term Growth
It also stands to reason that the more time you remain invested in any asset or fund, the more time your money has to grow, particularly in bullish markets.
- It Goes Beyond Short-Term Market Volatility
Over the short term, markets may be highly volatile. However, mutual funds that invest in fundamentally strong companies or high-growth stocks may be better positioned to ride out such short-term fluctuations
How to Maximise the Power of Compounding in Mutual Funds?
Now that you have seen what compounding is and how it works in mutual funds, you can use this theoretical knowledge to gain some practical advantage in your investment plan. Here are some strategies that can help you make the most of your mutual fund investments and tap into the power of compounding to the fullest.
- Begin Your Investment Journey Early
The earlier you start investing, the more time your money has to grow. Essentially, time amplifies the power of compounding and allows even small amounts to grow into significant wealth. Early investing gives your returns more chances to generate further returns, thus accelerating the compounding process.
- Remain Consistent With Your Investments
Even if you started investing later in life, you can still leverage the power of compounding by investing consistently. Regular contributions to your preferred assets and schemes can help your money grow without any interruptions. Each investment adds to your corpus and can boost your potential long-term returns.
- Consider Systematic Investment Plans (SIPs)
SIPs in mutual funds add an element of discipline and consistency to your investment strategy. By investing a fixed amount regularly, at periodic intervals, you can benefit from rupee cost averaging and steadily build a corpus over time. This drives the power of compounding, especially over the long term.
- Reinvest Your Dividends
This strategy taps into the essence of what compounding is. Instead of withdrawing the dividends that you earn from your mutual funds, reinvest them by purchasing more mutual fund units. This will add to your portfolio and allow your returns to generate additional potential returns.
- Consider Funds With a High Growth Potential and Strong Fundamentals
Growth-oriented funds focus on companies that have a high potential for growth. This essentially means that if the stock prices grow as expected, the rate of returns will be significantly higher than the market average. As a result, the impact of compounding will also likely be higher.
Conclusion
With this, we come to the end of our guide on what compounding is and how it works in mutual funds. You can include the pointers discussed in this article to improve your mutual fund investment strategies. Ensure that you account for the role of time in enhancing the power of compounding. You will then find it easier to strategise your mutual fund investments and align them with your goals, whether they are short-term targets, medium-term goals or long-term milestones.
You can also rely on a compound interest calculator or a mutual fund SIP calculator to better understand what compounding is and how it can impact your returns. This way, you can compare different investment methods and amounts and identify the most suitable way to invest in mutual funds.
Disclaimers:
- An Investor education and Awareness initiative by Tata Mutual Fund
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Source:
¹ https://www.amfiindia.com/indian-mutual