In the world of investing, the concept of compounding is considered to be one of the most powerful tools for potentially growing wealth over time. However, not many investors may realise the significance of the frequency of compounding on growth.
Compounding cycles can be annual, semi-annual, quarterly, monthly or daily. Of these, daily compounding can potentially be the most powerful but is offered by very few investment avenues.
However, recognising its importance can help investors understand the true potential of compounding and find ways to leverage it in their investment decisions.
Understanding daily growth
Compounding happens when the returns or interest on an investment are added to the principal amount and go on to earn further returns or interest. With compounding, the principal amount keeps growing, resulting in exponential growth over time. The compounding frequency determines how often these gains are added to the principal amount.
For instance, in annual compounding, the returns or interest earned on an investment over the course of a year will be added to the principal at the end of the year. For the subsequent year, further returns or interest will be earned on this increased principal, and this cycle will continue throughout the investment tenure.
In daily compounding, the potential returns or interest are added to the principal every day. This can result in potentially higher growth over time, as the principal increases every day.
Let’s see this with an example. Let’s assume you invested Rs. 1,00,000 in an avenue where you earn 5% returns annually. If these returns are compounded annually, your investment will grow to Rs. 1,05,000 at the end of the year – a gain of Rs. 5,000.
However, with daily compounding, your investment value at the end of 12 months would be Rs. 1,05,127.
While this may seem small, that daily compounding can make a big difference over a longer period.
Investment vehicles offering daily growth potential
As mentioned earlier, daily compounding in its pure sense is offered by very few instruments. However, there are some investment options where daily growth can play an important role, either directly or indirectly.
1. Savings accounts and fixed deposits
Some banks may offer high-yield savings accounts and fixed deposits (FDs) where the interest is calculated daily but credited monthly or quarterly. While the interest may not be paid out daily, the daily calculation still has a compounding effect.
2. Overnight securities
Some short-term debt instruments and money market instruments that have an overnight maturity have the potential to offer daily growth. Overnight funds are debt mutual funds that invest in securities such as treasury bills, certificates of deposit and reverse repos that mature overnight. They are usually considered low risk and can offer comparatively better returns than savings accounts. However, returns on overnight funds are not fixed or guaranteed.
3. Mutual funds
While mutual funds don’t compound daily, the daily fluctuations in the Net Asset Value (NAV) contribute to an ongoing opportunity for growth. However, the investment value can either increase, decrease, or stay the same. So, such investments don’t witness linear or predictable growth. Returns are not guaranteed and depend upon market movements. However, daily market movements have an impact on the investment, sometimes favourable and sometimes negative.
4. Stock market investments
Though stocks themselves don’t compound daily, the daily price fluctuations can simulate the effect of daily growth (or de-growth, depending upon market conditions). Investors who reinvest their dividends back into the stocks may additionally experience accelerated growth, especially over longer periods.
Calculating growth potential
To truly understand the power of daily compounding, it’s important to see it in action. A daily compound interest calculator can help you project how much your investment can grow over time with daily compounding.
Let’s take the example of an investment of Rs. 1,00,000 and an interest rate of 7%. Let’s see the investment growth for this over a year assuming different compounding frequencies:
- Annual compounding: The investment value comes to Rs. 1,07,000 at the end of the year.
- Semi-annually: Investment value comes to Rs. 1,07,123 over one year.
- Quarterly: Investment value comes to Rs. 1,07,186 over one year.
- Monthly: Investment value comes to Rs. 1,07,229 over one year.
- Daily: Investment value comes to Rs. 1,07,250 over one year.
Similarly, to track and project potential returns on your mutual fund SIP investments, you can use an SIP calculator online. This tool estimates how regular contributions, combined with the power of compounding, can potentially grow over time. However, most standard SIP calculators assume an annual compounding frequency. Moreover, their estimates are based on your inputs and actual returns will depend on market conditions.
Conclusion
While daily compounding frequencies may not be offered by too many investment avenues, understanding its potential can help you get a better grasp of investment concepts, the power of compounding, and the importance of reinvesting potential returns and staying invested for the long term. This, in term, can help you become a more well informed and strategic investor. Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
