Role of compounding in SIP

Sometimes we wonder, “Wouldn’t it be great if our money worked as hard as we did so that it helped us improve our existing financial condition?”. Thinking is way is quite understandable as we all want to achieve some monetary goals or the other at different stages in our lives. Some individuals have short term goals like buying a new car, going on a vacation with their loved ones, or simply renovating their house. Others have more long term and crucial financial goals like building a commendable retirement corpus, accumulating education corpus for their children’s higher education, etc. Financial goals may vary from individual to individual. However, through proper financial planning and investment planning it might be possible to achieve them over a decent time period.

One way to create long term wealth can be by investing in market linked schemes like mutual funds. A mutual fund is an investment vehicle that pools financial resources from investors sharing a common investment objective and invests the pool of money across fixed income securities, money market instruments, and various asset classes. Mutual fund investments need time to grow and perform to their fullest potential which is why several investors prefer starting a Systematic Investment Plan in mutual funds.

What is a Systematic Investment Plan?
If you are new to mutual funds, you may not have come across the term SIP and lump sum. Sometimes even existing mutual fund investors are left confused with the term SIP as they believe that it is a mutual fund scheme in itself. However, SIP is not a mutual fund investment scheme but a mere tool to invest in mutual funds. The other way to invest is by making a onetime lumpsum investment. But usually, a lot of investors prefer SIP as it is a much convenient approach. A Systematic Investment Plan allows retail investors to save and invest a predetermined sum at regular intervals. Investors generally prefer a monthly SIP because that way a fixed sum is saved and invested from their earnings in a disciplined manner.

Investing in mutual funds via SIP has several benefits and one of them is the power of compounding.

What is compounding in mutual funds?
The power of compounding in SIP investments can be witnessed by investors who have a long term mutual fund investment strategy. Two essential components for one’s investments to witness the power of compounding are – long term investment horizon and reinvestments of the accrued earnings. In compounding, the interest earned from the initial investments in mutual fund SIPs is reinvested in the scheme. Over the long term, the reinvested sum that is added to the principal investment starts earning interest of its own. This way, investors will not only benefit from their initial investments but might also be able to earn interest from the reinvestments in the long run.

Investors who want to witness the true power of compounding may have to start investing at an early stage in their life. Here’s a simple example to understand why it is beneficial to invest in a mutual fund via SIP:

Ramesh and Bikram started investing a monthly SIP sum of Rs. 2,000 in mutual funds. Both wished to retire early at the age of 50. However, Ramesh started his investment journey at the age of 35 and Bikram started his SIP journey at the age of 25. The assumed return from the mutual fund is 8%.

Since Bikram started his investment journey 10 years earlier than Ramesh, he was able to earn a whopping Rs. 12.18 lakhs more than Ramesh.

This is the power of compounding. Investors can use the SIP calculator, a free online tool, to make such calculations to determine the assumed returns from their SIP investments.

What are the other benefits of SIP?
Systematic Investment Plans have other benefits as well and one of them is rupee cost averaging, a technique that averages out the investor’s cost of purchase. Since the SIP investment sum remains stagnant, investors can buy more units when the NAV of the scheme is low and fewer units when the NAV of the scheme is high. Since mutual funds are constantly facing volatility, investors may be able to buy more units in the long run, thus averaging out their overall cost of purchase.

Investing in mutual funds via SIP might be a good approach, but investors need to understand that mutual funds do not guarantee capital appreciation. Hence, investors are required to consult their financial advisor to make an informed investment decision.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully