How does compounding work if we change Mutual Funds every year?

Many people feel that in order to benefit from compounding, one needs to stay invested in the same fund through out.

Before we examine whether this is indeed true, first let us understand what does compounding actually mean.

What is compounding?

We hear this term used very often, especially in the context of investments.

But what does it exactly mean?

In very simple terms, compounding means that profits generated from the investment in one period gets added to the base amount for the next period's returns.

So your 'base' amount increases every period (because of the profit) without you having to add more money to it.

That's it.

For example - If you invest Rs 100 in an FD which gives 7% interest, then at the end of the year you will have Rs 107.

If for the next year, the FD calculates 7% on Rs 107, then the FD is giving you compounding interest. The interest for the second year will be 7% of Rs 107 = Rs 7.49

On the other hand, if for the next year also, the interest is calculated on just the starting amount i.e. Rs 100 (and not Rs 107), then your interest for the second year would again be Rs 7 only. In this case, the FD is not giving you compounding interest.

(In general FDs provide compounding interest.)

How does compounding work in the case of Mutual Funds?

In case of FDs, the investment returns are fixed so it is easier to visualise the compounding.

But, how does it work in case of stocks and Mutual Funds?

(Equity) Mutual Funds invest your money in stocks based on their investment strategy.

Every month they sell some stocks which may no longer be attractive and buy new stocks based on their research.

When they sell stocks, there would be some profits made from that stock (not always, but in general).

Now these profits are not paid out to the Mutual Fund investor but are re-invested into their next stock pick.

Eg let's say your original investment was Rs 100. This was invested in stock A by the Mutual Fund. The stock moved up by 10% in a year and was sold, there by resulting in the MF getting back Rs 110.

Now, when the MF manager invests in their next stock, she will invest the entire Rs 110 in it.

So when the next stock makes a 10% profit, then the 10% profit is made on (the original amount + the profits from the last stock which were re-invested) i.e. on Rs 110, there by taking the overall value to Rs 121.

This leads to compounding over time.

The % returns are not fixed but they compound year on year as the Mutual Fund re-invests the profits into its next stock picks.

Conversely, if the profits were paid out (eg as dividends) then the compounding effect wont be there because the 'base' amount would not increase over time.

By the way, this is the reason why we don't recommend Dividend Mutual Funds, esp for non-retirees.

The one rule for compounding

So there is actually only one necessary condition for compounding:

The profits need to be re-invested and not taken out.

As long as you are investing in the stock market for a long period of time, without taking out your profits periodically, you will get the benefit of compounding.

What if we change Mutual Funds?

When we change Mutual Funds, we are not removing any money from the investments as such (assuming we rebalance only exit load free investments).

The profits from the first Mutual Fund also get re-invested into the next Mutual Fund thereby increasing the base for the next year of growth, thus leading to compounding.

So for compounding the main thing is that you should remain invested in some Mutual Fund and not necessarily the same Mutual Fund.

(By the way this applies to other things in life as well - e.g. as long as you can carry over your expertise from one job to another, your career will 'compound'. :) )