SIP Returns - How SIPs Benefit from Power of Compounding

How SIPs Benefit from Power of Compounding

A lot of people wish to invest in mutual funds because they aspire to create wealth, but very few have the patience of systematic and regular investing. For those who do not know, mutual funds are an investment vehicle where investors share a common investment objective in a ‘mutual fund’ that is generally owned by an AMC or a fund house. What these AMCs do is that they invest this pool of funds collected from investors across various money market instruments including equity, debt, corporate bonds, government securities, T-bills, call money, commercial papers etc.

SEBI, the regulatory body of mutual funds in India, describe them as, “a mechanism for pooling the resources by issuing units to the investors and investing funds in securities in accordance with objectives as disclosed in the offer document. Investments in securities are spread across a wide cross-section of industries and sectors and thus the risk is reduced. Diversification reduces the risk because all stocks may not move in the same direction in the same proportion at the same time. Mutual fund issues units to the investors in accordance with the quantum of money invested by them. Investors of mutual funds are known as unitholders.”

When you invest in mutual funds, there are two options available - you can either make a lumpsum investment or you can start an SIP. We will first understand the difference between SIP and lumpsum investment before proceeding further.

Lumpsum payment in Mutual Funds

As the name suggests lumpsum payment in mutual funds refers to making the entire payment of your investment amount at one go. When you make a lumpsum investment in a mutual fund scheme, you pay the entire investment amount at the beginning of the investment cycle. Another good thing about lumpsum investment is that mutual fund investors are allotted more units in quantum with the money invested and depending on the fund’s existing net asset value or NAV. So anyone who has surplus cash parked that they feel they can put to better use, you can consider investing in mutual funds by making a lumpsum payment

What is Systematic Investment Plan

Systematic Investment Plan or SIP is a systematic investment approach towards mutual fund investments. Individuals seeking long term capital appreciation through regular, disciplinary investments can consider the option of SIP investment. To start a SIP in a tax saving scheme like Axis Long Term Equity Fund, all you need to do is instruct your bank and every month on a fixed date, a predetermined amount is debited from your savings account and electronically transferred to your fund. SIPs may even inculcate the habit of regular investing in an individual.

How SIP investments can benefit from compounding?

To understand how SIP mutual fund investments can benefit from compounding, you may have to first understand how compounding works.

To simplify, compounding in mutual funds refers to the interest earned on the interest or profits earned on the profits from your investments. Power of compounding might help smaller investments to grow and fetch decent returns in the long run.

Anyone who wishes to benefit from compounding may have to start investing at an early stage in their life. This way you have more years in hand and time is your friend. The more time you have to invest in mutual funds via SIP, the better it is. When you start an SIP, every month a fixed amount gets invested in your mutual fund. Investors receive shares in the form of units in quantum with the money invested and depending on the fund’s existing net asset value (NAV). When the NAV is high, less units are allotted. Similarly, when the NAV is low, mutual fund investors are allotted more units. If you continue investing this way for a long period of time, and gradually increase the monthly SIP as per the fund’s performance, you may be able to benefit from compounding.

Investors should be able to realize that wealth creation is almost impossible to happen overnight. The lengthier your investment horizon is the more SIPs you can add to your fund and the better chances you have of benefiting from a powerful tool like compounding. It’s never too late to start an SIP with mutual funds. Obviously if you start early, you automatically have more years in hand to build a corpus. But remember that just having a lot of years in hand isn't going to prove beneficial if you are not regular with your SIPs. You will have to make sure that you do not withdraw your mutual fund units beforehand else you will lose out on the chance of benefiting from the power of compounding.

Also, before investing your hard earned money in any mutual fund scheme, make sure that you do some basic background check about the fund. Invest in a fund that has a proven track record, a fund that has been consistent over the years in yielding returns. Also check for other aspects, like, expense ratio, asset allocation, risk profile, etc. to get a clearer picture about the mutual fund. Lastly, if you are entirely new to investing do not shy away from seeking professional help before investing in any type of scheme.

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