Disclosures and Caveats: Compound Interest Periods
Why Compound Interest? Yearly vs. Monthly vs. Daily Compound Interest Calculations
The annual returns shown in Inv. Return and Dividend are all Annual Returns, Compounded Daily. Daily Compound Interest calculations use complex formulas (as opposed to Simple Interest, “I doubled my money in 10 years so my annual return is 10%”) and are accepted by almost all finance professionals as the correct way to express the return on an investment or compute the future value of a current amount. Investment Return uses compound interest calculations in all 3 of its calculators. The compounding used by Investment Return is Daily except for the future value calculation in Retirement Calculator for Annual Contribution, which is monthly to match the way most people make their contributions. When you hear the S&P increased x% in this period, that interest rate is almost always an Annual Return compounded daily/monthly/yearly. The returns shown by Inv. Return and Dividend can be compared with Industry Benchmarks (Dow, S&P, NASDAQ), bond interest rates you might be able to receive, and CD rates you can receive from financial institutions. So if Inv. Return tells you made 8.3205% on a stock investment and you knew you could only get 5% on bonds of similar risk during the time you held the stock, you know the money you put in the stock did better than you could have made in bonds for that time period. If you hear the S&P lost 15% a year for the last two years and Inv. Return shows you some of your stock investments made +2.4367% over the last two years, you know your stock investments did better than the S&P for that time period.
Compound Interest vs. Simple Interest?
A person could say I doubled my money in 10 years so my annual return is 10%. This is a Simple Interest calculation and is not accurate for the purposes of your planning. The truth is you can double your money in 10 years with a 6.93% return compounded daily, a 6.95% return compounded monthly, or a 7.18% return compounded yearly. All these returns are less than the 10% return computed using Simple Interest. So using Simple Interest overstates the return you need to accomplish the financial goal of having a certain amount of money in the future. Money now is always worth more than money in the future (Time Value of Money) because you could take the money now, put it in a money market account, and have more money in the future. Compound Interest calculations take the time value of money into consideration.
Daily vs. Monthly vs. Yearly Compounding:
Compounding has to do with how often the interest is computed, added to the principal balance, and then interest computed again against the new higher balance. So for example, if I make a $100,000 investment and I am promised a 10% return compounded annually for two years, this is what would happen. At the end of the first year $10,000 interest would add to my $100,000 initial investment. At the end of the 2nd year I would receive $121,000 = (10% of $110,000) + $110,000). All compound interest calculations in Inv. Return and Dividend use daily compounding. Two other common compounding time periods are monthly or yearly. Just to give you an example of how compounding is used, Money Market funds tend to compound interest daily. CD’s tend to compound only for the holding period, typically a year, 3 months, or 6 months. Daily compounding tends to imply a lower interest rate for a given investment than monthly or yearly compounding. The chart below shows the difference between daily, monthly compounding, assuming you double your money in 1 to 30 years. You can see as the years increase the difference between daily compounding and yearly compounding decreases.
Table that shows Daily, Monthly and Yearly compounding for doubling your money, from 1 to 30 years: