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Why Fixed Deposits are not investments?

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In a country like India Fixed Deposits (FDs) with banks are still a major form of savings and investments. I have seen this financial instrument being primarily used in my parent's generation and I can understand this trend given:

  • In their age they should aim for capital preservation versus taking risks and chasing returns.

  • For them stock market was always an elusive dream and majority of shares they used to hold were in form of papers or through a physical brokerage house. This in itself is a limitation factor because a lot of old age people do not realise how easy it has become to invest and track electronically.

  • Stock market requires constant tracking, comes with a risk and at this requires new learnings, something people from our parent's generation might not be comfortable with.

That being said, I understand the hesitation my parents have when it comes to stock market investments. I completely get it when they want to park their money in FDs or real estate. Also, it makes sense financially for my parents because:
They are retired and hence do not have a high primary source of income, this reduces their tax liability on FDs.

They are eligible for senior citizen FD rates which is a better deal than what we as young generation gets.

Given they don't understand stocks so well, they shouldn't invest in it. As Warren Buffett said, never invest in a stock/business you don't understand.

All this being said, what surprises and disappoints me the most is that a significant portion of people from my generation (including my colleagues, friends and peer group) also use FDs as their primary investment instrument. I have seen people happy about putting money in FDs and calling it out as an investment. A good investment is something which appreciates over time and can provide you with significant upside if it's held for a longer period of time, none of which is provided by an FD. Now before jumping into analysis of FD as an investment vehicle let's refresh our understanding of "inflation" as a concept as we would be using it in this article going forward.

  • Inflation is the rate by which your money is losing it's purchasing power, that means if you were able to buy 100 potatoes (or take example of any of your favourite vegetable) with 100 Rupees now, you will be able to buy only 96 potatoes next year with 100 Rupees, because India's inflation rate is at 4%. That is, your money is losing it's value by 4% every year. Hence, if you do not invest your money and keep it in cash you are actually making loses of at least 4% per year. With the concept of inflation in our mind let's analyse returns from FDs.

  • What returns do you actually get when you invest in an FD?
    The current rate of returns on FDs is 6.5% for a maturity of 1 year. Given you are taxed on FDs as per your income bracket let's see tax adjusted returns on FDs:

    • For tax slab of 20%: Tax adjusted returns = 6.5% * (1-20%) = 6.5% * 0.8 = 5.2% 

    • For tax slab of 30%:Tax adjusted returns = 6.5% * (1-30%) = 6.5% * 0.8 = 4.55%

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Now let's adjust these returns for inflation (as your money will lose this much value over a year): [Consumer price Inflation rate for FY20 as expected by Govt. = 4.4%]

  • For tax slab of 20%: Inflation adjusted returns =  5.2% - 4.4% = 0.8%

  • For tax slab of 30%: Inflation adjusted  returns = 4.55% - 4.4% = 0.15%

 

Thus you are earning a returns of 0.2% to 0.8% on your FDs per year which is actually very low w.r.t returns you can actually generate on your hard earned money. This equation actually turns negative for FDs of shorter duration and savings bank returns (which means you are actually losing money versus making any gains).


FDs historically are grossly misunderstood as an investment choice and we need to rethink our relationship with them. FDs are never meant to be your primary investment, rather it should be an avenue where you can park your excess cash for short term and generate better returns than savings account. FDs can help you preserve the value of your money but don't expect them to make any money for you. Now when you know the problems with FD, I will be discussing below instruments which you can use to generate better returns and make your money work for you.

Investment instrument recommendation based on your risk appetite: [Don't know your risk appetite, take a quick assessment here]

  • Conservative investors: Invest in corporate bonds or debt mutual funds which generate higher returns than FDs and with significantly lower risk than stocks.

  • Balanced investors: Invest in a mix of debt instruments like bonds, equity investments like stocks/mutual funds (click here to learn mutual fund investments) , gold and real estate (click here to learn hassle free investments in real estate).

  • Aggressive investors: Majority (70%+) of funds should be in equity with remaining portion spread across debt, gold and real estate.


Thus I recommend young generation to take charge of their personal finances, invest time to understand basics of investments, make your hard earned money work for you !

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