The money that you invest in a mutual fund scheme is your principal and the excess that you may earn on it gets compounded over the investment period. Effectively speaking what happens here is, that excess earned on your principal investment gets added back to your principal. Now, your principal will consist of the excess amount earned, if any. This results in an increasing rate of growth for your mutual fund investments in case of excess, however may be negative in case of losses.
Here’s an example for you to consider (*this is just an illustration, it should not be taken as the basis for making any investment decision, actual results may vary) –
If you invest INR 1,00,000 (principal amount) for a year at 10% p.a. interest rate in mutual funds, at the end of the year you can earn INR 10,000 as additional amount on it. Now, upon reinvestment of the excess amount earned, the total maturity amount at the end the year would be INR 1,10,000.
Similarly, if you stay invested for 20 years, without adding further to the principal amount and at 10% p.a. interest rate, you could stand to earn approximately INR 6,00,000. This amount would be a result of the compounded amount as opposed to the INR 3,00,000 that you would have earned in total, had the excess amount not been compounded over the years.
It is important to note that compounding can potentially show great effects as the tenure of your investments increases. Therefore, investors are advised to start early and stay invested for the long term to enjoy the benefits of compounding.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.