Mutual funds are often touted as the best investment option. Besides high return and diversification of investment, what makes mutual funds an attractive and wise investment choice is compound interest. Compounding is a magical concept which allows you to automatically multiply your money.
What is Compounding in Mutual Funds?
Mutual Funds entail two types of earnings – Dividends and Capital Gains. If instead of withdrawing, you keep your earnings invested in a mutual fund scheme you can get the benefit of compounding. Compounding basically means that you earn returns not only on your principal investment but also on the returns generated from that investment. This growth, calculated using exponential functions, happens as you earn returns from both your initial principal investment as well as the accumulated returns generated by the initial investment over successive periods.
Let’s understand this better with the help of an example. Suppose both Mr. A and Mr. B invest Rs. 50,000 each in ICICI Prudential Bluechip Fund – Direct Plan (growth option) on 29 January, 2014 for 5 years. While Mr. A keeps his earnings invested in the mutual fund scheme, Mr. B opts to withdraw the earnings annually. The ICICI Prudential Bluechip Fund has given an annualised return of 18.16% over the last 5 years period (as on January 29, 2019). The below table illustrates the returns earned by both Mr. A and Mr. B on their investment.
|Mr. A||Mr. B|
|Investment Year||Investment Value at the Beginning of the year (Rs.)||Withdrawal Amount (Rs.)||Year-end Value of Investment (Rs.)||Investment Value at the Beginning of the year (Rs.)||Withdrawal Amount (Rs.)||Year-end Value of Investment (Rs.)|
|Earnings||Rs. 65,165||Rs. 45,400|
Thus, Mr. A earns Rs. 19,765 more than Mr. B over the same investment amount invested for the same number of years.
This is how the power of compounding helps you in multiplying your money in mutual funds. You can read about the top 5 mutual fund schemes for 2019 here.