Financial planning is essential for building a secure future. Apart from traditional savings avenues, mutual fund investments can help potentially earn inflation-beating returns and grow wealth in the long term.
A convenient and affordable way to invest in mutual funds is through Systematic Investment Plans (SIPs). SIPs allow you to invest an amount of your choice into a mutual fund scheme at regular intervals, such as weekly, monthly, quarterly etc. Over time and with consistent investing, you can potentially build a substantial corpus.
However, starting your investing journey early is important to leverage the power of compounding and optimise long-term return potential. In this article, we’ll explore what compounding is and how a long investment horizon benefits SIP investments.
Understanding the power of compounding
Compounding is a powerful financial concept where the returns on your investment generate their own returns. When you invest in a mutual fund scheme, you potentially earn returns. If those returns are reinvested into the scheme, you can earn further returns on these. Essentially, you earn returns on both your initial principal and the accumulated returns. The longer you stay invested, the more pronounced the effect of compounding can become.
How compounding works in SIP
Let’s break down how compounding works in the context of SIP investment through an example. Let’s assume you start an SIP investment of Rs. 1,000 per month and earn an average return of 12% per annum. After one year, you would have invested Rs. 12,000 and earned Rs. 809. When this entire amount is reinvested, your effective principal for the next cycle becomes Rs 12,809, on which a further 12% growth will be accumulated. Please note that these calculations assume a fixed and consistent rate of return. In reality, returns are not guaranteed and can fluctuate based on market conditions.
Over time, your investment can potentially grow at an accelerated rate as the base amount on which returns are generated grows, resulting in a snowball effect.
Let’s look at this through an example*. Let’s assume two friends start an SIP of the same amount (Rs 1,000 monthly) in the same scheme where they expect to earn 12% per annum. Person A starts investing at the age of 25, while Person B starts investing at 35. Let’s see how much both will earn by the time they turn 60.
Person A:
Invested amount: ₹5,000 per month for 35 years.
Total investment: ₹21,00,000.
Estimated corpus at age 60: ₹3,27,00,000.
Person B:
Invested amount: ₹5,000 per month for 25 years.
Total investment: ₹15,00,000.
Estimated corpus at age 60: ₹1,54,00,000.
*Note: The example given above is for illustrative purposes only. There is no guarantee or assurance that these figures will be achieved.
Despite investing only ₹6,00,000 more, Person A’s corpus is more than double that of Person B, thanks to the power of compounding.
An SIP calculator or a compound interest calculator can help you understand this potential accelerated growth. By inputting your SIP amount, expected rate of return, and investment tenure, you can estimate your future return potential using these tools and select a suitable investment horizon.
Benefits of starting SIP early
- More time for compounding: The earlier you start, the more time your investments have to compound. Even small amounts can grow substantially over a long period.
- Rupee cost averaging: By investing a fixed amount regularly, you buy more units when prices are low and fewer units when prices are high. This averaging out of purchase prices can reduce the overall cost per unit of your investment. This further optimises growth potential.
- Disciplined saving: SIPs inculcate a habit of regular saving and investing. It ensures that you invest a fixed amount periodically, regardless of market conditions, promoting disciplined financial behaviour.
- Flexibility and convenience: SIPs are highly flexible. You can start with a small amount, increase your investment amount as your income grows, and even pause or stop the SIP if needed. This flexibility makes SIP investments convenient for investors with varying financial capacities.
- Reduced financial stress: Regular SIP investments can reduce financial stress by spreading your investment over time. You don’t need to worry about timing the market or making large lump-sum investments.
We can thus see that the power of compounding can significantly enhance the growth potential of SIP investments, especially when you start early. Using tools like a compound interest calculator can help you visualize your potential returns and make informed decisions.
Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.