How Does Compounding Work In Mutual Funds

What is Compounding? 

The term "compounding" is used to describe the process of reinvesting a profit in the hope of increasing that profit. Allow me to illustrate with an example. 

Let's pretend you want to make a long-term investment and so you deposit Rs. 1 lakh into a cumulative fixed deposit. The deposit period is 5 years, and the interest rate is 10% per year. You can use an RD calculator, which is an internet tool, to figure out how much you can invest in RDs. A recurring deposit is an investment in which a set amount is made on a regular schedule, usually monthly, for a predetermined period of time. Interest accrued on the principal balance is reinvested at the end of each year, making the compounding period one year. Up to the time of maturity, the interest will be reinvested. 

At the conclusion of the 5 years, your initial investment of 1 Lakh will have grown to approximately Rs 1,61,051, including interest of approximately Rs 61,051. 

If your fixed deposit didn't use compounding, you would have earned around Rs. 50,000 less in interest. To counter this, compound interest helped you earn an additional Rs 11,051 (Rs 61,051 - Rs 50,000). Dig deeper with the Compound Interest Calculator.

As you can see, the power of compounding can significantly speed up the time it takes to amass a substantial fortune. 

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How Compounding Works In Mutual Funds? 

Now that you know the basics of compound interest, let's examine how it operates in the context of mutual funds.

Mutual funds, as you may know, put your money into a number of different companies' stock. On occasion, the stocks in a mutual fund will issue dividends, which are collected by the fund house. Fund companies typically pay out dividends in cash to investors on a pro rata basis depending on the number of units they own.  

Investors who want to take advantage of compounding might do so through a dividend reinvestment plan. This plan operates like a cumulative fixed deposit, with dividends reinvested into the original mutual fund. With this strategy, you can increase your holdings in the fund by the accumulation of additional units after the payment of dividends. 

When this dividend reinvestment is done over a lengthy period of time, say, about 10 years, the number of units you finish up having will be much more than what you would have had if you hadn't selected for the reinvestment option. 

Here's an illustration of the compounding effect at action in a mutual fund. Suppose you invest in 1,000 shares of a mutual fund at a NAV of Rs. 25 per share. It is your intention to keep this investment for the foreseeable future. Your annual dividend is about Rs. 100, and you put it back into the same fund. By doing this, you can acquire an extra four shares per year. If you keep reinvesting your dividends over the course of the 10 years, you'll have 1,040 units at the end instead of 1,000. 

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Conclusion

As you can see, the compounding effect and dividend reinvestment work together to considerably boost results. The best aspect is that you don't even have to do anything; everything happens automatically. 

Now, if you want to invest in mutual funds, you'll need trading and demat accounts set up in your name. Paytm website is where you may sign up for a Demat account and a trading account. The full application can be completed in a matter of minutes online. After opening a trading and demat account, you will be able to invest in stocks, mutual funds, initial public offerings (IPOs), and many other types of assets.

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