Compounding is one of the most powerful concepts in the realm of investing. It allows your investment to grow not just on your initial principal amount but also on the returns or interest you’ve earned over time. However, there are different types of compounding frequencies, and each can affect your return potential.
This article will look at how different compounding frequencies can impact your growth and why it is important to understand this when managing finances.
Before we dive deeper into the effect of compounding frequency, let’s first understand compound interest. Compound interest is the interest calculated on the initial principal and also on the interest that has been added to it in previous periods. Unlike simple interest, which is only calculated on the original investment, compound interest can potentially grow your money exponentially over time.
Different compounding frequencies
Compounding can occur at different frequencies, and these frequencies affect how often the interest is added to your investment, which in turn impacts your overall return. Let’s look at some of the most common compounding frequencies.
As the name suggests, daily compounding means that the interest is added to your account every single day. The more often the interest is compounded, the more interest is added to the principal. So, if two avenues offer the same per-annum interest rate, the one that offers daily compounding will offer better return potential than the one that offers monthly, semi-annual, or annual compounding. However, there are very few avenues with daily compounding. You can make use of a daily compound interest calculator to get an estimate of the returns over time.
With quarterly compounding, interest is calculated and added every three months. This means your investment earns interest four times in a year. While not as fast-growing as daily compounding, quarterly compounding can still offer better returns than annual compounding.
In half-yearly compounding, interest is calculated twice a year. It’s commonly used in traditional savings schemes and fixed deposits in India. While this method helps your investment grow, it does so at a slower rate compared to daily or quarterly compounding.
Annual compounding is when the interest is calculated and added once every year. It can be slower than the other compounding cycles listed above but is widely used.
Example: daily vs. quarterly compounding
Let’s consider an example to help you understand the difference. Assume you invest Rs. 10,000 at an interest rate of 10% per annum.
As you can see, the more frequently the interest is calculated and added, the more your money grows. Over longer horizons, the impact of this is more pronounced. Let’s look at this for the example given above, this time, assuming an investment horizon of 5 years.
How does this impact your mutual fund SIP investment?
Mutual fund SIP investments involve making regular, fixed contributions towards a mutual fund scheme. The power of compounding plays a significant role in making your SIP grow over the long term. However, compounding does not happen in a linear manner or at a fixed frequency in mutual funds. It is used as a measure to assess the performance of a mutual fund over time, assuming that returns are reinvested.
When you invest in mutual funds, you do not earn a fixed interest. You earn potential returns, and the rate depends upon market movements. So, on every business day, your investment value can increase or decrease, depending upon prevailing market conditions.
However, if you stay invested – i.e., do not withdraw your returns – the amount of money that gets market exposure grows over time. As a result, a compounding-like effect happens, where you can earn further returns on reinvested returns, resulting in a snowball effect over time.
So, while daily compounding doesn’t play out in mutual fund SIPs, understanding the concept can give you a grasp of the power of compounding and the importance of staying invested for the long term to get optimal growth potential.
Mutual Fund investments are subject to market risks, real all scheme-related documents carefully.
