How mutual fund SIPs benefit from power of compounding

The not so secret recipe in the wealth creation is the “power of compounding”. The concept of compounding is simple. Power of compounding is nothing but interest earned on interest or profits earned on profits. The power of compounding over a long horizon, if invested in the right asset, is enormous. The chart below shows the growth of Rs 1 Lakh investment over various time-scales, assuming 12% annualized returns. You can see in the chart that the growth is not linear, it is exponential.

In elementary school arithmetic we were taught the difference between addition and multiplication – the power of multiplication is much more than that of addition. Power of compounding in wealth creation is multiplicative not additive – your wealth will multiply if it remains invested for long tenors. In the chart above, your wealth multiplied 10 to 50 times over investment tenors of 20 to 35 years. Longer your investment tenor, higher is the wealth creation.

Secret ingredient of wealth creation recipe

From the chart above, it should be clear what the secret ingredient is – it is time. Most of us do not understand the value of time. We think there is lot of time to accomplish things, but the hard reality of life is that the clock is always ticking every second. By the time you finish reading this article, you will have less time than you had before. From a wealth creation stand point, time is the most important factor in investing, much more important than factors like market levels, valuations (PE ratios), current economic and political scenarios etc.

Money must grow

Just like we work to earn money, money works to earn money. Unfortunately, while we work hard to earn money, most of us do not make our money work hard. Money is put to work for us, when it is invested. It cannot work for us, if it lies in low yielding savings bank account. Every rupee invested by us works in making more money for us. Therefore, you should put every rupee you save to work to make money. If you save and invest more, you will create more wealth. More importantly, the longer you make your money work, the more wealth you will be making.

Systematic Investing

Very often, I hear investors say that, I do not have sufficient savings because of expenses, home loan EMIs, vehicle loans so on so forth. These investors are missing the point. Rs 5 Lakhs invested for 5 years at an annualized return of 12% will yield a profit of Rs 3.8 Lakhs. The same money spread over 20 years at a monthly instalment of just Rs 2,080 will yield a profit of Rs 24 Lakhs. You do not need a sufficiently large investible corpus to create wealth, investing from your regular monthly savings, even if it is a small amount can help you create substantial wealth. This is the essence of systematic investments. The power of systematic investment is unlocked through compounding and the key to its success is discipline. Mutual fund Systematic Investment Plans or SIPs is a proven way to create long term wealth from your regular monthly savings.

Mutual Fund SIP

Mutual Fund Systematic Investment Plans (SIPs) were introduced for the first time in India in the late nineties. Over the past twenty years or so, mutual fund systematic investment plans have become one of the favourite saving and investment choices for retail investors in India. SIPs offer a simple and disciplined way to accumulate wealth over the long term. Mutual Fund SIPs work like bank recurring deposits, except that, they are subject to market risks and are able to generate superior risk adjusted returns compared to bank recurring deposits. SIPs in good funds have generated excellent returns and created wealth for the investors over a long investment horizon.

There are a number of benefits of investing through Mutual funds Systematic Investment Plans for long term financial goals. One of the main advantages of investing through Systematic Investment Plan is that it makes disciplined saving and investing convenient. By submitting an ECS mandate for SIP, the SIP amount (as specified by you) will automatically get debited from your bank on a particular day of the month (or any other frequency) specified by you and get invested in the mutual fund scheme of your choice, till the time you stop the SIP.

Usually the savings invested in SIP would otherwise be spent on some discretionary item or remain idle in the savings bank account. By investing your savings on a regular basis, you are putting your money to work to make more money.

The other big advantage of SIP is that, it makes market timing irrelevant. It is not possible to predict accurately how markets will be have. By investing at a regular frequency, e.g. monthly, one is invested both at the high and the low points of the market. SIPs work well in volatile markets, by averaging the cost of the investment.

The biggest advantage of mutual fund systematic investment plans is that, it can create wealth with relatively small regular savings over a long investment horizon through the power of compounding. The table below shows a scenario analysis of the corpus built over various periods of time at different investment return rates, with a monthly SIP amount of Rs. 5000/-

Examples of wealth creation through SIP

The chart below shows the returns of Rs 5,000 monthly SIP in Indiabulls Bluechip Fund over the last 5 years. With a cumulative investment of Rs 3 lakhs, you could have accumulated a corpus of more than Rs 4.2 lakh over the last 5 year against your investment of Rs 3 Lakhs. The SIP XIRR is 13.8%. Please see the detailed performance of the fund.

There is a misconception that SIP works only for equity funds because it takes advantage of volatility through Rupee Cost Averaging. Remember the essence of SIP is the power of compounding; rupee cost averaging is an auxiliary benefit. SIP works as well for more conservative investment options. The chart below shows the returns of Rs 5,000 monthly SIP in Indiabulls Savings Income Fund since inception, nearly 3 years back. With a cumulative investment of Rs 1.7 lakhs, you could have accumulated a corpus of more than Rs 1.97 lakh over the last 2.75 years. The SIP XIRR is 10.8%.

Please see the fund details here.

Conclusion

You can see that by investing a portion of your regular savings in mutual funds in a disciplined way through SIP, you can accumulate a large corpus over a sufficiently long investment horizon. During a market downturn, the investment value may temporarily decline a bit, but at the same time, through SIP you will be investing at lower prices which will get you superior returns in the future. Through SIPs investors can create a win-win situation for them over long investment tenures. The power of compounding through SIP is indeed magical for long term investors.