Have you ever come across those suspense stories where a secret fact or object remains hidden in plain sight until the climax? The same thing happens with compounding in the world of investment. While many people may not understand what compounding is, others may be ignorant of it.

Albert Einstein wasn’t exaggerating when he proclaimed compounding to be the eighth wonder of the world. After all, the power of compounding enables everyone to create significant wealth through regular investments.

So, let’s understand what is the power of compounding and how it can help you grow your wealth exponentially in the long run.

Understanding the Power of Compounding

The compounding definition in finance is simple to understand. It is the process of accumulating interest on interest and works on the formula of compound interest discussed in the next section.

In other words, the interest is added to the principal amount, and the process is repeated for the entire investment period.

Compound Interest Formula & Example

Following is the formula to calculate compound interest.

Compound Interest = P (1+r/n) nt - P

Where,
P = Principal or Initial Amount
r = Rate of Interest expressed in percentage
n = Number of times the interest compounds in a year
t = time in years.

Now, let’s understand the power of compounding meaning by applying the above formula in the following example.

Consider a scenario where you have invested ₹1,00,000 in a mutual fund for 10 years. Further, consider that your money compounds at an annual rate of 8% during this period. Now, consider these two scenarios.

Scenario 1:

You choose to receive the interest amount annually.

In this scenario, you'll receive ₹ 8,000 annually as an interest amount. Therefore, you will receive Rs 1,80,000 by the end of your investment tenure.

Scenario 2:

You choose to reinvest and receive the entire amount at the time of maturity.

In this scenario, the interest amount you receive each year is ploughed back into your investments. Hence, your investment grows at a better speed.

Let's apply the compound interest formula to your investments, as illustrated below.

A= 1,00,000 (1+(8%)/1) 10 =2,15,892

Therefore, you receive ₹2,15,892 after 10 years, a considerably higher amount than Scenario 1. The difference would be significantly higher if you stay invested for a longer period.

3 Steps To Get the Benefits of Compounding

You choose to reinvest and receive the entire amount at the time of maturity.

In this scenario, the interest amount you receive each year is ploughed back into your investments. Hence, your investment grows at a better speed.

Let's apply the compound interest formula to your investments, as illustrated below.

A= 1,00,000 (1+(8%)/1) 10 =2,15,892

Therefore, you receive ₹2,15,892 after 10 years, a considerably higher amount than Scenario 1. The difference would be significantly higher if you stay invested for a longer period.

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3. How Much Should You Invest to Build a Corpus of ₹1 Crore in 10 Years?

How much you need to invest every month in the SIP of your preferred scheme depends on the annual returns you’re expecting from the investment. While there is no way of predicting future returns, you can get an idea by looking at the historical returns of some of the shortlisted funds.

Once you know your expected returns and the SIP amount you can invest, you can get a better idea of the amount you may need to invest to reach your target.

Here is a table on the SIP amount you’ll need based on the annual return that your investment generates to reach ₹1 crore.

Disclaimer: For illustration purposes only. Actual results may vary
Click here to use the SIP calculator and zero in on the amount you need to invest.

4. Know your Risk Appetite

Wouldn't it be ideal if there was no risk in investment? Unfortunately, however, no investment is free of risk. Moreover, as a rule of thumb in investments, the higher the return potential, the higher the associated risks. Therefore, it is essential to know your risk appetite and invest accordingly.

As per SEBI, the fund house must state the risk level of every mutual fund clearly in the Scheme Information Document (SID). The risk level is decided based on various parameters set by the SEBI. There are four levels of risk-

1. Moderate

2. Moderately High

3. High

4. Very High

As can be seen, you’ll have to invest ₹49,700 per month through SIP if the average annual yield is 10% and you want to build a corpus of ₹1 crore in 10 years. Everyone can't invest such a significant sum of money every month. In such cases, you can consider using the step-up approach.

With the step-up approach, you start with a lower SIP amount and increase it by a fixed percentage every year. As income generally increases with age, the surplus funds you can invest will mostly increase with time, making the step-up strategy highly practical for most investors.

Example

Disclaimer: For illustration purposes only. Actual results may vary.

So, you can start with an SIP of ₹24,279 in the 1st year and increase it by 15% to ₹27,921 in the 2nd year, and so on.

Building a Large Corpus Through Mutual Fund SIPs

How can I make 1 crore in 10 years is a common query among new investors. The tips discussed above can help if you have a similar goal. But as the information is based on assumptions and estimates, ensure that you do your research before investing.

As mutual funds are subject to market risks, you can also consider discussing your objectives with an investment advisor for professional guidance.

Disclaimer: Historical performance, when presented, is purely for reference purposes and is not a guarantee of future results.

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