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Understanding the Magic of Compounding and how SIPs help you realize it
May 25, 2018

The data from the Association of Mutual Funds in India (AMFI) showed a massive 53% increase in the investments made through mutual fund SIPs as against last year's (2017) data. Let's explore why the SIP route has become a favorite among investors.


Author : iFAST Content Team



"Discipline is the difference between what you want now and what you want most." This applies to achieving anything in life, financial goals being one of the trivial ones. Discipline and patience are the qualities to master before you can truly realize the power of compounding. What does this power grant you? Just about anything you need in this material world or may be more. Let's stick to ordinary mortals here and define some of your financial goals. Some of the regular ones include a dream home, funding your child's education, settling your children (though, they should do that themselves), seeing the world and most importantly living a peaceful retired life. How can the power of compounding help you achieve these?


The Power of Compounding

You don't need to be born rich to be able to create wealth. The key is to start investing early on, stay disciplined without giving into market fluctuations, and be patient. When the time comes you will have the dough to make that bread. Mutual funds can make this happen for you. When you invest in mutual fund, compounding allows you to earn returns on your initial capital and on the returns that you reinvest. It helps you build a large corpus over a period of time with the smallest of investments. That is why it is said that compounding is a long term investment strategy. The early bird sure gets the worm and more in this case. Examining the table in the following sections will help you understand the magnitude of the concept.

 

Mutual Funds and the SIP route

SIP (Systematic Investment Plan) is an investment option offered by Mutual Fund houses whereby you can invest a fixed amount in a mutual fund scheme for a specific duration of time at regular intervals. The data from the Association of Mutual Funds in India (AMFI) showed a massive 53% increase in the investments made through mutual fund SIPs as against last year's (2017) data.

The SIP route is a favourite among investors for various reasons:

• This is one of the easiest ways to start investing with amounts as small as Rs 500/ month, without having to accumulate wealth to start investing.

• SIP is a convenient method of investing through standing instructions to debit the investor's bank account every month, without the hassle of having to write out cheques.

• It helps you become a disciplined investor.

• It helps you benefit from market fluctuations by averaging out the cost price (Rupee Cost Averaging).

• It is the best way to reap the benefits of the power of compounding.

• Equity linked Saving Schemes through SIPs also help save taxes.


When should you start investing?

Let's examine this using example with some assumptions that the average SIP returns is 12% per annum and the bank RD interest rate is 8% (Average bank fixed deposit rate is presently around 7.5). The investment amount is Rs 5000/month.

 

This table helps us conclude the following:

• Longer the time of investment, more is the compounding effect

• SIP is better than regular bank deposits

• Starting early yields dramatic advantages


How much to invest

Your needs and goals determine how much to invest. The first thing would be to make that emergency fund for any unforeseen situation such as loss of job, or a health break or any such. Target to accumulate enough to run your household for a period of 6 months without your salary. Once that is done, identify your other financial goals. You now need to work backwards to arrive at that ideal figure you need to keep aside every month based on the current value of your goal, average expected returns and assuming an inflation rate of 6%.

Choosing the funds is an extensive research and intuition based game. It is best to involve an expert who does it based on your risk profile, goals (according to priority) and the time at hand. As an investor you should try to invest 30% of your income in SIPs. Be wise and step up your SIP every year at least by the current inflation rate. As Dave Ramsey said "Through knowledge and discipline, financial peace is possible for all of us."



Disclaimer: iFAST and/or its content and research team's licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's scheme information document including statement of additional information. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer on the website.



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