Mutual funds are professionally-managed investment vehicles that are increasingly becoming the preferred choice of investment for many investors. The primary reason for its appeal is the relatively higher returns it offers as opposed to traditional forms of investing. Plus, it provides high liquidity as you can withdraw whenever needed. However, experts recommend staying invested for the long-term for enhanced benefits.
This article looks at how to invest in mutual funds via Systematic Investment Plans (SIPs) to build wealth.
Understanding the power of compounding
Compounding plays a pivotal role in mutual fund investments to help grow your money. It does so by generating earnings on your previous earnings along with the base capital. This results in substantial growth of your funds provided you have a long-term investment horizon of 5 years or more.
Let us see how compounding works in mutual funds.
Suppose, you invest Rs.1 lakh as an initial investment for 15 years. Assuming a rate of 10% per annum as compound interest, your funds by the end of 15 years would amount to Rs.4,17,725. This is how compounding earns interest on interest and results in higher wealth accumulation.
Investment through SIP
Most experts advise investing in mutual funds via regular SIP investments as it builds the habit of saving consistently.
SIP in mutual funds has many benefits, including rupee cost averaging. Since you invest regular sums at different levels of the market cycle, you can average the purchase cost of units in the long term. This is because when the markets are low, you can purchase more units and vice versa. The profits you make via SIP investments can be reinvested in the mutual fund scheme and compounded upon thereby translating to a larger corpus.
Let us look at how power of compounding can make a difference in your earnings.
Say, you invest Rs.1 lakh annually for 5 years. At the rate of 10% compound interest, your money would grow to Rs.6,71,561 at the end of the term. The total interest earned would be Rs.1,71,561.
However, if there were no compound interest, a flat interest rate of 10% per annum for 5 years would leave you with an interest of Rs.50,000 (5 lakh x 10%). The difference in interest would be Rs.1,21,561 (1,71,561 – 50,000), i.e. almost 3.43 times more than the interest you earned.
Conclusion
As a new investor, if you are wondering how to invest in SIP, here are some easy steps:
- Start by understanding your risk tolerance level and the objective of your investment.
- Decide for how long you wish to stay invested.
- Choose a mutual fund scheme that meets your investment profile and set up a SIP with an auto-debit facility.
Remember, compounding works best when you stay invested for a while, preferably over 5 years. So, if you anticipate you may require funds in the short-term, consider investing in liquid funds and short-term debt funds.