Systematic Investment Plans offered by mutual funds are a great way to build wealth over a long period of time.

If you are a seasoned investor, you probably know that.

But do you know how SIPs are successful in increasing wealth?

Well, we’ll reveal the secret.

It is a mathematical concept called compound interest. (Trying to remember high school Mathematics?)


Also Read: 13 Things You Need To Know About SIP

What is an SIP?

SIP stands for Systematic Investment Plan. It is an organized way of investing in mutual funds of one’s choice, usually at fixed time intervals.

Generally, SIP allows for a certain amount of money, decided by the investor, to be automatically deducted from the investors account and invests it in a mutual fund of the investor’s choice.

Depending on the NAV for the day, the amount of SIP is allocated towards buying certain units of the mutual fund.

This process repeats every month automatically without the interference of the investor. Thereby, saving time and cost of the investor and ensuring regularity.

An important benefit of the SIP scheme is the benefit of rupee-cost averaging over long periods of investment.

Since mutual funds are purchased at different rates every time you pay the SIP installment, the investor benefits from the power of compounding and rupee-cost averaging.

What is compounding?

The concept of compounding can be well understood by comparing it with the snowball effect.

As we roll a small-sized snow ball down a hill, it continuously picks up snow on its way down.

By the time it reaches the bottom of the hill, it becomes a larger snow boulder form a small snow ball.

The snowball can be said to have compounded on its way down the hill. As it goes down the hill, the snowball packs more and more snow; getting bigger in the process.

The snowball effect is a metaphor for the mathematical phenomenon called compounding.

The word compounding means that every year interest is calculated on the total amount of money accumulated by the end of that year, which includes the principle and the interest.

Since interest continues to get added to the principle, compounding usually generates better results over a long period of time.

In order to understand the concept of compounding with more clarity, let us look at a very simple example.

Let’s assume, a 25 year old starts investing ₹ 1 per month at a 10% rate of return till he reaches 65 years of age. At the end of the 40 year period, he will have a sum of ₹ 6,324.08.

On the other hand, suppose a 30-year old person starts investing ₹ 1 per month at a 10% rate of return till he reaches 65 years of age will have only ₹ 3796.64.

We can see from this example that despite the amount of investment and return rate being the same, only a difference of 5 years amounted to a difference of more than 50%.

This is the magic of compounding!

At 14%, any investor will have twice as much wealth than someone who starts investing just 5 years later.

This difference grows exponentially as the number of years of investment increases.

Also Read: Best SIP plans for high returns in 2018

SIPs and Compounding

Investing in SIP enables money to work in order to make more money. The phenomenon of compounding is the catalyst to this process.

One of the biggest advantages an investor gets out of investing in a mutual fund systematic investment plan is that, it has the power to generate wealth with relatively small regular savings.

SIPs bring out discipline in the investing process. It enables investors to invest regularly, without fail, irrespective of the short-term performance of the fund.

Investment into mutual funds via the SIP mode, for a long-term investment horizon, overcomes the problem of timing the market.

Remember, the essence of compounding is time. Which means, staying invested in the market, through ups and downs alike.

Conclusion

Compounding is truly a life-changing phenomenon.

It is very basic, yet extremely important to implement while investing in general and mutual funds in particular. Time is money, literally.

Compounding helps your money make money, in the sense that over a long period of time, interest is earned not only over the principal amount invested but also on the interest.

However, all investors, existing and prospective, must be aware of the fact that investment in mutual funds and equities alike, entails risk.

Therefore, all decisions of investment must ideally be guided by the investment objective of the investor.

The return expectation and risk appetite of the investor are important considerations which must be evaluated before investing.

Also Read: When is the right time to invest in lump sum and SIP?

Happy investing!

Disclaimer: the views expressed here are of the author and do not reflect those of Groww.