Monthly Compounding Better Than Annual? Not Always

If you have spent any time thinking over your investment strategy for future, you would be knowing pretty well the power of compounding. And to go with it, the fact that daily compounding is better than monthly which is better than annual and so on. Lesser the compounding period, more the profit for you. If you haven't come accross this by now, let me explain it to you first. After that I will tell you how monthly compounding is not always better than annual.

Let's suppose you have $1000 and put it in a fixed deposit. This FD offers you 12% interst rate per annum. We will calculate now the money you would get after 5 years when compounded monthly: 1000*(1+12/1200)^60 = $1816.70 . When compounded annually, you get 1000*(1+12/100)^5 = $1762.30.

So does that mean you should always go for monthly compounding? No, not at all. Choosing the compounding period depends on the frequency or time interval of investments. Let us take two seperate investment strategies. We would keep the interest rate constant for both of them at 12% per annum. In strategy1, we would invest $100 per month for 12 months and opt for monthly compounding. In strategy2, we would invest $300 per quarter(every 3 months) for one year. That way, our net investment for the year in both cases is $1200. Let us see what returns do we get in each:

Strategy1 gives return of $1281.

Strategy2 gives return of $1292.74 !

Weigh your options carefully before investing that money.