Power of Compounding

When we borrow money, we pay interest. When we lend or invest money, we earn interest. Interest is a percentage of the principal for a given time frame. if that interest get added to the principal then This larger principal now generates slightly more interest, and so on … This the power of compounding interest which make our money to work in our favor.


The compounding is the ability to grow an investment by reinvesting the its earnings/interest- was referred to by Albert Einstein as "the eighth wonder of the world." The magic of compounding allows investors to generate wealth over time, and requires only two things: the reinvestment of earnings and time. If we have two investment ideas with slight different rate of interest then in longer period it will have grate difference in  corpus.

CASE #1

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Suppose there are three people A, B and C. All three have decided to  invest 10 thousand per month for 20 years. but  they have chosen three different investment options on which they earned average return on there investment as 12%, 15% and 17% respectively . The corpus accumulated at the end of 20 years would be 98,92,554 rs ,1,49,72,395 rs  and 1,99,46,590 rs. We can easily see the difference in ROI is only 5% yearly but corpus is almost double.

CASE #2

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As mentioned above that compounding needs time to do the magic. If in the above example B and C have some other commitments towards life so they have not started investment with A. B starts investment after 3 years than A and C starts after the 5 years. All three have earned same return yearly say 12%. After 20 years, the corpus would be 98,92,554 rs, 66,13,078 rs and 49,95,802 rs for A , B and C respectively. C has invest only 5 years less than A but the corpus is reduced to half of A. This is only because C has given only 15 years to his money to grow while A has given 20 years. Hence the time is equally important as ROI. If someone starts early he will be the winner.

CASE #3

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In above example C starts after 5 years but what if someone invests for 15 years and stay invested for 20 years. Suppose B starts after 5 years and C invest for 15 years but stay invested for 20 years. All three have earned same return yearly say 12%. so after 20 years the corpus would be 98,92,554 rs, 49,95,802 rs and 90,75,857 rs.  B&C have invested only 5 years less than A but the corpus of B is reduced to half of A. and the corpus of C is almost 90% that of A.

Magic of compounding works with time and ROI. So start early and stay invested for longer term. 

Expense ratio of a mutual fund

Expense ratio tells that how much a fund is expending to run the business. Rest would be invested. We cant judge a fund on the basis of expense ratio. It is used for all type of expenses like salaries, agent commission, office expenses etc. A good fund manager can charge more salary than the other fund manager. A newer fund house may offer higher commission to its agent. All these are included in expense ratio. Since this is charged regularly (every year), a high expense ratio over the long-term may reduce your returns through power of compounding. 

As per SEBI regulations, the maximum expense ratio of an equity fund can be 2.5% and for a debt fund, it should not cross 2.25%. There is an additional allowance 0.3 per cent given for selling in Tier II and Tier III cities for equity schemes. The return from an fund returns is always exposed after such expense ratio.

The expense is charged on daily basis. Suppose some fine day NAV of a fund is 100rs and it is moved 5%then the final NAV would not be 105. If the expense ratio is 2% then the expense ratio for that particular day would be 2%/365 (that’s 365th part of 2% as charges, as it’s for 1 day, remember 365 days in a year) and the final NAV would be 105-0.5479=104.45rs.

There is no correlation between expense ratio and performance. So don't decide the fund to invest on expense ratio. There are other elements to consider before coming to expense ratio. Go for the fund which has good consistent CAGR return for 3 to 5 years against its benchmark. If there are two equally good performers and one has a lower expense ratio than the other, then you should perhaps go for the first one.