Power of Compounding – The Eighth Wonder of the World

For children, probably the toughest task is to resist the temptation of having all of their favourite sweet in one go. Ask children to save a little bit of the sweet for later and they will look at if as if you tried to be really funny but failed miserably. The idea of saving something good for later is something that children just don’t understand.

And why blame them? They’re children, after all. Even us adults don’t understand the benefits of saving for later. Take the example of our tax-saving investments. The day the investments start earning really good returns, we start contemplating redeeming them and reaping the benefits right away. However, the finest benefits of tax-saving investments are reaped not in the short-term, but over longer periods of time. This is because it is over the long-term that the power of compounding really starts showing its magic.

If you told a child to save her favourite sweet for later, she would agree if you told her that the sweet would grow bigger if she saved it for longer. A small piece today growing into a bigger chunk over time. That seems like reason enough to save–for a child as it should be for an adult.

With tax-saving investments like Public Provident Fund, ELSS funds, National Savings Certificate, etc, the small savings you put periodically in them can translate into a big corpus if you stay invested and keep investing. This is because these investments earn compounding interest.

Compounding interest is when one year’s interest is added to the next year’s principal and in the second year, interest is earned on both the principal and the interest. When this happens year after year, the results end up being phenomenal. With compounding interest, you basically earn on not only what you invest but also on what you’ve already earned.

For example, let’s say you begin investing Rs 10,000 a year in these tax-saving investments and your portfolio earns 10% interest, the closing balance for the first year would be Rs 11,000. Next year, you would invest another Rs 10,000 and if the portfolio earns 10% interest again, it would be calculated on Rs 21,000. This way, year after year, your interest would get added to your investment and you would earn on both.

tax saving investments

The following table shows how compounding interest turns a small amount every year into a big corpus. We have taken 10% as the rate of interest through the 10 years.

Year Opening Balance Investment Interest Closing Balance
1 10,000 1,000 11,000
2 11,000 10,000 2,100 23,100
3 23,100 10,000 3,310 36,410
4 36,410 10,000 4,641 51,051
5 51,051 10,000 6,105 67,156
6 67,156 10,000 7,716 84,872
7 84,872 10,000 9,487 1,04,359
8 1,04,359 10,000 11,436 1,25,795
9 1,25,795 10,000 13,580 1,49,375
10 1,49,375 10,000 15,937 1,75,312
Total 1,00,000 8,28,430

*figures have been rounded off to the nearest decimal

As per the above table, if you invested Rs 10,000 every year, your invested amount of Rs 1,00,000 would grow to a corpus of Rs 8,28,430 thanks to compounding interest. And this is when assuming a rate of return of 10% while a diversified portfolio of tax-saving investments can earn anywhere between 13-15% over a long period of 10 years and more.

Now, doesn’t that sound magical. It is, which is why compounding interest is called the 8th wonder of the world by Albert Einstein. Compounding interest is also one of the primary reasons why experts recommend tax-saving under Section 80C. This is where these investments offer a win-win situation for investors–tax saving and wealth creation thanks to compounding interest.

This article was also published on Yahoo Finance on 26 May 2016.

Image courtesy of Stuart Miles at FreeDigitalPhotos.net.

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