When FDs aren’t the best :: Business Line

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Sticking to the safe route can cap your returns, putting your goals in jeopardy

There are several reasons why fixed deposits should be your preferred choice of bond investments in the absence of tax-free bonds.

The most important is the maturity value of the deposit. If you invest ₹10 lakh today in a five-year deposit that earns 9 per cent interest compounded annually, your maturity value will be ₹15.38 lakh. Knowing how much you will receive at maturity can help you plan your savings to achieve your life goals.

But having a large proportion of your portfolio in fixed deposits can be harmful. Here’s why.

Conservatism is risky

Let’s assume, one, you need ₹60 lakh towards down payment to purchase your dream house six years hence and, two, that equity investments can generate 12 per cent per annum returns and fixed deposits, 6.3 per cent post-tax (30 per cent tax rate).

Now, suppose you are able to set aside ₹7.5 lakh at the beginning of each year in an investment account towards down payment for the house.

Based on the expected post-tax returns, you have to invest 60 per cent in fixed deposits and 40 per cent in equity to meet your goal. You may still fail to achieve your goal if the actual equity return is lower than 12 per cent in any year.

But what if you are conservative and invest more in fixed deposits? The expected return on your portfolio with, say, 90 per cent fixed deposits and 10 per cent equity will be 6.87 per cent; expected return is lower because fixed deposits dominate the portfolio. Even if the actual return was equal to the expected return, you will fall short of your goal by about ₹3.25 lakh.

This is because the compounded annual return required for accumulating ₹60 lakh with a yearly investment of ₹7.5 lakh is about 8.5 per cent. Investing a large proportion in fixed deposit lowers your portfolio’s return, leading to failure of the intended goal. The shortfall will be higher if your investment amount is lower.

An associated issue is that interest income is the only source of return on fixed deposits. You should, therefore, reinvest the interest income. But will you? You will be always tempted to consume interest income. If you are inclined towards investing more in fixed deposits, adopt the threshold value approach.

Consider again your life goal to accumulate ₹60 lakh (20 per cent) towards down payment for your dream house worth ₹3 crore. Assume the minimum (or threshold) amount you need to buy a house is ₹2 crore.

You should, therefore, invest in monthly recurring deposits such that you accumulate ₹40 lakh in six years to meet the threshold; additional savings should be invested in equity to earn the balance ₹20 lakh.

If your fixed deposit investment provides the floor; you will be able to buy a smaller house even if you lose your equity investment. Besides, recurring deposit offers cumulative interest.

So, you are not subject to the risk of consuming your interest income. The advantage with the threshold value approach is that you are using the surety of the maturity value of fixed deposits to meet your threshold life goal and then applying the balance savings to aim for the higher level goal.

But remember, you have to invest in equity if you wish to achieve your dream goal. If you are compensated for taking risk (read: equity investments), not taking risk can be risky (read: failure of goal)!