Why Investing in Fixed Deposits is a Big Mistake ?

Card image cap

One of the most frequently asked questions we get is "What’s the right place to invest?" One way to think about it is what kinds of investment should be pursued and what should be avoided. 

However, we should begin by asking an even more fundamental question, How do you define an investment? Everyone has a different definition, for us, to qualify as an investment the asset has to give returns (After-tax) that is at least a couple of percentage points over inflation for a holding period of 5 years or more. If you need specifics, we suggest you aim for at least a 12% CAGR (The average year-on-year growth rate of an investment) over a period of 5 years.

Well, just going by the definition above, you should opt FD’s out as an investment asset because you will not be able to earn an after-tax return higher than 7% consistently, even if you fall in to the lowest tax bracket of 10%. That may be acceptable to some, but it becomes unattractive when you get inflation in to the equation. A return less than 7% is unlikely to beat inflation in the long-term (India’s long-term average inflation rate is approx. 7%) and that is worrisome as the money you withdraw from your fixed deposit in future will purchase less amount of goods and services than you can today with the same amount of money.

The most significant drawback however, is something which is not even considered by 90% of us. It is the opportunity cost of not investing our surplus money in an alternate investment asset like Mutual funds. For example, if you invested Rs 1 Lakh every year in mutual funds and got a modest 12% returns (CAGR) vs. putting the same amount in a FD giving an interest of 7%, the respective investment value after 25 years would be 1.33 Crores for Mutual funds Vs. 63 Lakhs for FD (Refer to the illustration below) i.e. a difference of earning in lakhs vs. crores.

                                                  

You must be thinking, the probability of losing money in equity mutual funds is much higher and therefore, much riskier. Well, you may be right if you pick a low quality fund and sell it in the short term without doing any research or do not monitor and review your investments regularly. However, please note that the average returns of even conservative equity funds in last 5 years is over 12% also,  the Sensex market index has never given negative returns over any 10-year period since 1994, which includes the dot com crash of 2000 and the 2008 financial crisis- the worst market crashes in recent times.

If you buy the logic outlined above the key question then is: Why do we in India still have 56% of our savings in Bank deposits? It is because FDs are perceived as safe instrument, which incidentally is true but, is safe good enough? Let us try to answer the question by trying to understand another key term associated with investments - Risk. 

Risk can be measured based on 2 parameters.

1. Return of Capital: FD’s score high here as the probability of you losing money is remote.

2. Return on Capital: This is where FDs actually let you down big time as the returns after adjusting for inflation and taxes will be negative, especially if you are in the higher tax bracket. Therefore, it is riskier in terms of achieving your long-term important goals like retirement planning or your children’s higher education.

So, are we suggesting that one should not put any money in Fixed Deposits? Not at all, what we are proposing is that Fixed Deposits is not an asset where majority of your savings should be parked for the long term. Use them only to fund your short-term goals i.e. goals less than 2-3 years away where liquidity and predictability is more important than quantum of actual returns.

We hope this blog has given you a new perspective on fixed deposits and that, you will think through before deciding to put all your hard earned money in to Fixed Deposits next time you have surplus money in your hands.

Research Desk

Everguard Life Ventures Pvt. Ltd.


Back to Blog