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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5 things to know about fixed deposits

With interest rates rising over the last one year, fixed deposits have become popular again.

But there are certain things that you should know about fixed deposits before they go around investing in them. Here are five must-knows about fixed deposits:

1. Interest paid either monthly or quarterly

The interest on a fixed deposit is usually paid out either monthly or quarterly depending on the option that the investor chooses. So an individual investing Rs 1.5 lakh (Rs 150,000) in a one-year fixed deposit paying an interest of 8% per annum will get Rs 1,000 per month (8% of Rs 1.5 lakh divided by 12; or Rs 3,000 per quarter (8% of Rs 1.5 lakh divided by 4).

Other than this, those depositing money in a fixed deposit also have the reinvestment of interest option available.

2. The yield or return on a fixed deposit is different from interest.

An interest of 8% in a year would mean a return of 8.24% in a year for those individuals who opt for the reinvestment of interest option.

What this means is that Rs 100 invested at the beginning of the year will amount to Rs 108.24 by the end of the year. This is because the interest earned is compounded every quarter.

An interest of 8% in a year would imply an interest of 2% in a quarter. Hence Rs 100 invested by an individual would earn an interest of Rs 2 (2% of Rs 100) at the end of three months. So the Rs 100 investment made by an individual would have amounted to Rs 102 by the end of three months (Rs 100 + 2% of Rs 100). Since this interest is reinvested, the individual earns 2% interest on Rs 102 for the next three months. The interest earned for the next three months is Rs 2.04. This interest is also reinvested and the individual earns an interest of 2% on Rs 104.04 for the next three months.

Repeating this process at the end of the year, the individual has accumulated Rs 108.24 and hence a return of 8.24%, which is higher than the interest of 8%.Given this individuals putting money in a fixed deposit who do not need a regular income from the fixed deposit, it makes more sense for them to opt for the reinvestment of interest option and earn a greater return.

3. Want to break a fixed deposit? Careful

At times it might become necessary to break the fixed deposit either because the money is immediately required or for the fact that other banks have started offering a higher rate of interest on the deposit.

Breaking a fixed deposit has a cost attached to it. Most banks, on premature withdrawal, give an interest which is 0.5% lower than the interest applicable for the period for which the deposit has remained with the bank.

Let's try and understand this through an example. An individual makes a three-year deposit, paying an interest of 9% per annum. Due to urgent need of money he may have to break the deposit at the end of one year. The bank for a period of one year pays an interest of 8.5%. The individual will be paid an interest of 0.5% less than 8.5% which is 8%.

4. The interest earned on a fixed deposit is not tax free

The interest earned from a fixed deposit gets added on to the income for the given year and is taxed according to the tax bracket that an individual falls into. Hence, for those falling in the top tax bracket the interest earned from a fixed deposit is taxed at the rate of 33.99%.

5. It is possible to take loans against fixed deposits

This works out to be cheaper and involves less paper work vis a vis taking a personal loan.

By -- Chandnee Sinha