Mutual funds are a favorite vehicle for most retirement and pension funds and with good reason. They diversify portfolios, and historically, they have delivered good returns. But as a pool of assets owned by a pool of investors, how do they grow?
Mutual funds are compounded. Investors earn interest on their principle plus earned interest and dividends that are reinvested into the fund; however, the interest is not paid at a fixed rate as with compound interest. Funds are compounded like other products: monthly, quarterly, or annually.
The rest of this article will discuss the difference between compound and simple interest, explain how mutual funds are compounded, determine the disadvantages of compounding, and explain how the time value of money makes patience an essential part of investing.
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Table of Contents
What Is the Difference Between Simple and Compound Interest?
Simple interest is what most people are familiar with because that is the method most savings accounts use to pay interest. Using this method, banks pay a fixed percentage annually on the principal amount deposited.
For those who want to dust off their math skills, the Simple Interest Formula is:
A= P * r * n
Where,
- P = the principal amount you invested
- r = the annual interest rate
- n = the term (how often is it paid)
Compound interest is calculated on the initial principal and the interest it accumulates over previous periods, so the more periods it compounds, the more money you make.
The Compound Interest formula is one you likely learned in Algebra class, which means you have to remember your order of operations.
A= P(1+r/n)nt
Where,
- P = principal
- r = annual interest rate
- n = number of compounding periods
- t = time in years
Mutual Funds Experience Compound Growth
How mutual funds are compounded is a topic for debate, and it adds to the confusion for investors. Still, the concept does not need to be complicated.
Dave Ramsey, whom many consider to be the guru of personal finance and wealth management, argues that mutual funds do not experience compound interest because the fund’s value can rise and fall, meaning there is no fixed interest rate.
On the other hand, Investopedia says that mutual funds do receive compound interest.
Since both are highly respected and reputable sources, it is unlikely that either is wrong, which prompted the initial question: Are mutual funds compounded?
To clarify, Dave Ramsey is correct, as he most often is; technically, mutual funds do not receive compound interest in the truest sense of the word because they do not have a fixed interest rate.
However, Investopedia is also correct that mutual funds are compounded because the growth your mutual fund receives comes from the principal investment, accrued interest. Then it earns interest on that accrued interest when the money remains invested.
For this reason, Dave Ramsey prefers the term Compound Annual Growth Rate over Compound Interest. For some, this differentiation in terms will seem negligible, but there are some for whom the explanation is vital.
Either way, though, as long as the expense ratio is in your favor, and the fund is balanced, and there is not much turnover within the fund, mutual funds grow more the longer they are left alone.
All Mutual Funds Are Not Created Equally
Although mutual funds do compound, they are not always the best investment, and your financial portfolio needs a balance of investment vehicles to go along with mutual funds.
The first rule of investing is to know your financial objectives, and different mutual funds will meet different objectives. This knowledge is essential because of another investment term: the Time Value of Money (TVM).
For the most part, Mutual funds are meant to be long-term investments, which is why they are so popular in 401Ks and pension funds.
Even so, investors must understand that TMV, as defined by Investopedia, “is the concept that money you have now is worth more than the identical sum in the future due to its potential earning capacity. This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received.”
This concept is illustrated perfectly with the adage, “A bird in the hand is worth two in the bush.”
To put this adage into financial terms, the money you have today is worth more than the money promised tomorrow because of earning capacity and inflation. However, the growth experience of mutual funds makes it more beneficial to invest the money rather than simply hold it in a simple interest-bearing savings account.
Therefore, it is crucial to understand your financial objectives and see how they relate to the types of mutual funds available, which are:
- Growth and Income funds, also called large-cap funds, have historically enjoyed a solid performance and are considered low-risk investments.
- Growth funds are called mid-cap because they are made up of funds from companies that are still growing. These funds respond more to changes in the economy, but they still typically yield solid returns.
- Aggressive Growth funds are called small-cap funds because they are made up of small companies with considerable growth potential. They fluctuate much more than the other funds but also have a higher potential return.
- International funds are also called global funds made up of foreign-owned companies that you likely already do business with, like Trader Joe’s. These can be high risk because the fund is at the mercy of currency changes and other economies, but they also have a high potential for reward for the same reasons.
Because of the time value of money, you have to know how long you have for your money to grow and how much risk you can afford to take. In short, just because mutual funds are compounded does not mean they are the “magic potion” for achieving a healthy retirement pot. Due diligence and education are best when dealing with all financial matters.
Are There Disadvantages to Compound Interest?
One area of due diligence is to determine the disadvantages that may come with mutual funds and compounding so that you can make an educated decision.
It is clear that compound interest works against borrowers; however, compound interest can have disadvantages for mutual fund investors. Therefore it is crucial that you keep a close watch on your accounts.
The main problem with mutual funds and compound interest is that many people will invest in mutual funds too early. I know that sounds counterintuitive, but hear me out.
If you are carrying high credit card or student loan debts with compounding interest, you are likely losing money if you are investing in mutual funds or anything else, for that matter, before those debts are paid. The reason goes back to the TVM.
Another way people hurt their future wealth is by borrowing money from retirement plans. The problem here is not really with compound interest, but rather human behavior. However, your account loses the compound interest it would have earned.
Education Materials To Consider
- The Other Side of the Coin: Compound Interest from Amazon.com, discusses both the positives and the pitfalls of compound interest. The biggest problem is that people think it is a magic key to wealth. The author goes over ten myths about compound interest and shows you how to avoid pitfalls and make sure compound interest works for you.
- The Lost Science of Compound Interest from Amazon.com, exposes how to simplify complicated math concepts like compound interest so they can help you reach your financial goals.
- Compound Interest Secrets found on Amazon.com, shows readers how to simplify compound interest and use it to generate wealth.
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Conclusion
Mutual fund returns are calculated based on the asset’s compounding schedule, and that can be monthly, quarterly, or yearly. Even considering inflation and the time value of money, mutual funds are a vital investment option for retirement, in part because they are compounded.
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