SIP : The power of compounding

A systematic investment planning (SIP) allows the investor to invest in any mutual fund by making small periodic investments instead of a lump sum one-time investment. SIP is a proven method to beat market volatility and benefit from the power of compounding over time.

Compounding is one of the most powerful methods of wealth creation. Compounding means earning interest on interest. In simple interest, the investor earns interest only on the principal i.e. the amount that has been invested initially. However, in compound interest, the investor earns interest on the principal and additionally earns interest on the interest as well.

I will explain the difference of simple interest and compound interest with an example where the investor has invested Rs 1,000 for 10 years at 10% rate of interest per annum.

In case of simple interest, the investor will earn Rs 100 per year. At the end of the 10th year the investor will get back the initially invested principal of Rs 1,000 and you would have accumulated total interest of Rs 1,000 and thus get back Rs 2,000 in total.

In case of compound interest, in the first year, the investor will earn Rs 100 in interest. But in the second year, the investor will earn Rs 110 in interest on account of the interest on the initial principal of Rs 1,000 and the interest on the interest of Rs 100 earned in first year. Thus continuing in the tenth year, the investor will earn Rs 235.80 in interest. In 10 years, the power of compounding will grow the investor’s total investment of Rs 1,000 to Rs 2,594 as compared to Rs 2,000 in case of simple interest.

The example above illustrates what happens to Rs 1,000 which has been invested for one time over a period of 10 years. In SIP, if the investor invests Rs 1,000 every month then each of the SIP payments of Rs 1,000 is compounded and the investor benefits from the power of compounding.

Starting early in investing into mutual fund SIPs makes a significant impact to the investor’s total maturity corpus. For example, if an investor starts investing Rs 1,000 per month in SIPs from the time he embarks on his/her first job (assuming at the age of 25 years), the investor can build up a corpus of Rs 52 lakh at the time of retirement at the age of 60 years at an annualised return of 11% per annum. However, if the investor is late in starting the SIP of Rs 1,000 per month and starts at the age of 40 years, he would get Rs 9 lakh by the time he retires at the age of 60.

Thus the best way to take advantage of compounding is to start saving and investing wisely as early as possible.

POWER OF INVESTING

• Compunding means earning interest on interest and is a powerful tool of creating wealth
   
• In compound interest, the investor earns interest on the principal

The writer is chief investment officer, LIC Mutual Fund