Common Myths About Compounding Explained
Busting common myths about compounding with the help of a compound interest calculator
We often hear the phrase ‘Compounding is the eighth wonder of the world’. It’s an investment mantra that illustrates how compounding can potentially lead to significant investment growth over time. However, when it comes to understanding exactly how this process works, investors often have some doubts and misconceptions.
Compounding is the process by which the interest or returns on an investment are reinvested and generate their own returns. The concept of compounding is straightforward in fixed-income investments such as fixed deposits, public provident funds or savings accounts. That’s because these investments offer a fixed rate of return, resulting in steady and linear growth.
However, when it comes to mutual funds or other market-linked investments, the process can look very different. For such investments, compounding does not typically follow a smooth or predictable path, because returns are linked to market conditions and can vary Understanding this can help investors plan their finances better and approach their investments with more clarity.
Let’s take a closer look at some common myths around compounding in mutual funds that tend to mislead investors, especially those who have just begun their journey.
Myth 1: Compounding gives the same returns every year
People often assume that if a mutual fund has given a 12% annualised return over a certain period, that means their money has grown by 12% every single year. However, returns for market-linked investments don’t function like clockwork. Your portfolio might grow by 20% one year and might fall by 8%, and the year after that you could see a small gain of 6%.
Over time, the average annualised return could still be close to 12%, but that doesn't mean your money grew in a neat, upward line.
Tools like a compound interest calculator – while highly useful in planning and showing the potential power of compounding – can add to this confusion. The calculator uses a fixed rate of return for its estimates, while actual returns tend to fluctuate depending on market conditions.
Myth 2: You can catch up later by investing more
Many investors delay starting their SIPs or lumpsum investments, thinking they can simply put in more money later and still end up with similar returns. It feels practical—after all, income usually rises with time, so why not wait?
The problem, however, is that compounding relies heavily on time. The earlier you start, the more time your money potentially gets to grow.
Let’s say Rina invests Rs 2 lakh for 20 years in a mutual fund where she expects to earn 12% CAGR. Her friend Aman chooses the same fund but wants to invest only for 10 years, so he decides to invest Rs. 4 lakh.
Using a compounding calculator, you can see that even though Aman invested double the amount to make up for lost time, his corpus was still considerably smaller than that of Rina’s. When you enter the investment amount, tenure and expected rate of return, you will see that Rina’s corpus will potentially grow to Rs. 19.3 lakh in 20 years, while Aman’s will grow to Rs. 12.4 lakh in 10 years, simply because her money had more time to potentially grow.
*Example is for illustrative purposes only.
Myth 3: Compounding starts showing results quickly
New investors often expect to see big changes in the first few years of investing. When the numbers don’t move much, it feels like compounding isn’t working.
But compounding is like growing a plant. In the early years, the progress is slow. The big jumps usually come in the later years. That’s because your returns begin to earn returns of their own, resulting in accelerated growth over time. A compound interest calculator can illustrate this curve.
Myth 4: Once you invest, compounding takes care of everything
While it’s true that compounding rewards time and consistency, it doesn’t mean you can “set it and forget it” forever. Life changes, income changes, and so should your investments.
For instance, if you are investing through a Systematic Investment Plan (SIP) in mutual funds, increasing your SIP amount even by a small percentage every year can potentially make a substantial difference over time. That’s where an SIP top up calculator can be useful. The tool illustrates how adjusting your contributions as your earnings grow can increase your potential wealth over time.
To sum up, compounding can have a powerful effect on investment growth, but there are no guarantees. It can reward those who start early, stay invested, and tune out the noise. The real power of compounding lies in patience and persistence, not in dramatic returns.
So, next time you hear someone talk about the magic of compounding, remember – it’s not magic, it’s maths. And maths needs time, patience and discipline to potentially play out.
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