Are Bank FDs indeed safer than other investments?

We have usually heard investors seeking safe investments. Invariably bank fixed deposits are presumed to be safe. On the other hand equity investing is considered risky.

If we further get deeper into the thought process we will realize that fixed deposit is considered safe because under normal circumstances we get back the same principal amount that was initially invested. However, in case of equity we may get either more or less or same amount of initial investment.

Does this mean equity is risky or for that matter is fixed deposit really safe? Answer is No. There are varieties of risks that are associated with investments. Some of the risks are market risk, credit risk, liquidity risk, reinvestment risk, political risk, economic cycles etc. Broadly there are two types of risk systematic risk and unsystematic risk.

Systematic risk is a risk, which exists in the system e.g. inflation, taxes, political situation, economic cycles etc. This form of risk affects all our investments. Our returns from all kinds of investment like equity, debt, gold, real estate etc will get reduced to the extent of inflation. Suppose rate of inflation within economy (READ: System) is 7% and returns from equity, debt, Gold and real estate are 20%, 6%, 13%, 18% then our actual returns will be 13%, -1%, 6%, 11%.

Systematic risk is usually not transparent, e.g. we cannot see impact of inflation on our investment. The principal amount invested in fixed deposit is returned back to us completely. Therefore we feel that investment in fixed deposit is safe. However inflation would have eroded our returns from fixed deposit and hence to that extend fixed deposit is subject to systematic risk.

Another form of risk is unsystematic risk. This form of risk is associated with a particular kind of investment, e.g. if we buy land and if real estate prices crash, our investment will have a negative impact, however if we invest in Gold and if housing prices crash worldwide, the crash will not affect our Gold investment. Similarly, if we have bought stocks of Reliance Industries Limited and if something happens to Bajaj family there will not be any impact on the stock of Reliance Industries Ltd. Unsystematic risk does not exist in system, it only affects a particular investment.

Similarly, in case of fixed deposits, unsystematic risks could be credit risk or reinvestment risk.

Since we do not directly see the movement of fixed deposit prices, it does not mean it is risk free. In case of equity investment, its prices fluctuate based on impact of variety of risks. In case of fixed deposit investment amount remains constant but various risks quietly erode real value of principal. Simply because we cannot see the risk does not mean risk doesn’t exist.

As an investor we should always remember the fundamental of investments and its returns. Investor gets returns on investments because he takes the risk of parting with his/her money. The moment we part with our money, our investment inherits risk.

To conclude:

By all means invest in bank fixed deposit, Govt. bonds or any other investments which will help you reach your financial goals but never ever think that your investment is risk free 100%.

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