In Mutual Funds, How Does Compounding Work?

The term "compounding" refers to the practice of reinvesting a profit in the hope of increasing that profit. Here's a case study to illustrate the concept. 

Let's pretend you want to open a cumulative fixed deposit and decide to put away Rs. 1 lakh. The deposit has a 10% interest rate and a term of 5 years. Annual compounding means that the interest earned on the principal balance during the year is re-invested in the account at the end of each year. All accrued interest will be reinvested until the term of the deposit ends. 

Your initial investment of 1 Lakh will grow to around Rs 1,61,051 at the conclusion of the 5 year term. This includes approximately Rs 61,051 in interest. 

Without compounding, the interest you earned on your fixed deposit would have been around Rs. 50,000. However, compound interest allowed you to earn around Rs. 11,051 in additional interest (Rs. 61,051 minus Rs. 50,000). 

You can speed up the process of amassing wealth by employing the principle of compounding. 

How Compounding Works In Mutual Funds?

If you're familiar with compound interest by now, you might be interested in learning how it applies to mutual funds.

Mutual funds, as you may know, put your money into a variety of equities. Mutual fund management firms occasionally receive dividend payments from the equities in their portfolios. The fund company will then pay you the dividend to you in cash in proportion to the amount of units you own.  

If you're an investor who values compounding, you may want to consider participating in a dividend reinvestment plan. Like a cumulative fixed deposit, your dividends will be automatically reinvested into your chosen mutual fund under such a scheme. By reinvesting dividends, you can accumulate a larger number of fund units over time. 

For a lengthy period of time, say 10 years, the number of units you end up with through this dividend reinvestment will be far more than it would have been if you hadn't chosen the reinvestment option. 

To better illustrate how compounding works in a mutual fund, here is an example. Assume you invest Rs. 25,000 in a mutual fund and buy 1,000 shares. You're buying with the intent of holding for ten years. You receive a dividend of around Rs. 100 per year and reinvest it back into the same fund each year. Investing dividends back into the company nets you an extra four shares per year. If you keep reinvesting your dividends over the course of the 10 years, you'll wind up with 1,040 units instead of 1,000. 

Conclusion

As you can see, the compounding effect and dividend reinvestment work together to considerably boost results. What's even better is that you don't have to do anything; it's all done for you. 

Now, if you want to put money into mutual funds, you need a trading and demat account set up in your name. You may easily open a Demat account and trading account with Motilal Oswal by going to their website. The application itself can be completed in only a few minutes entirely online. You can start investing in stocks, mutual funds, initial public offerings (IPOs), and other assets as soon as you open a trading and demat account. 

Read Also : Why Should You Invest Your Money in Index Funds?

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