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Investing in FD's is a losing long term proposition

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Ajit Dayal discusses why investing in Fixed Deposits is not as attractive as investing in stock markets.

With the equity markets in the "doldrums", there have been a series of articles in the popular press about how investing in Fixed Deposits and in bank accounts is far superior to investing in stock markets.

As for gold, it is seen as some barbaric relic that only fools would throw their money at.

These arguments are flawed and distort the facts.

Readers of the Honest Truth are familiar with the table that is there at the end of every Honest Truth.

Suggested allocation in Quantum Mutual Funds (after keeping safe money aside)
  Quantum Long Term Equity Fund Quantum Gold Fund
Quantum Liquid Fund
Why you
should own
An investment for the future and an opportunity to profit from the long term economic growth in India A hedge against a global financial crisis and an "insurance" for your portfolio Cash in hand for any emergency uses but should get better returns than a savings account in a bank
Suggested allocation 80% 20% Keep aside money to meet your expenses for 6 months to 2 years

Disclaimer: Past performance may or may not be sustained in the future. Mutual Fund investments are subject to market risks, fluctuation in NAV's and uncertainty of dividend distributions. Please read offer documents of the relevant schemes carefully before making any investments. Click here for the detailed risk factors and statutory information"

Based on Table 1, it is obvious that investors should have exposure to various asset classes. The percentage allocated to each asset class may vary depending on the individual situation of the investors.

At the end of the day any investment we make is for:

  1. Peace of mind - to know that the asset is there when you may need it;
  2. To meet our present consumption in the future years - assuming that inflation will increase the price of whatever we consume today, our savings needs to find a way to earna return to match - or surge faster than - the rate of growth in prices,
  3. To meet future good events that you know will occur - getting married, having children, educating the children, arranging finances for their marriage, and buying a place to live,
  4. To meet future problems that may occur - illness, a loss of a job, a loss of a key earning member of the family.

Each of us will plan for the above in different ways. Some may believe that they will not get married. Some may feel that it is not their responsibility to educate their children through college or help in their marriage. Some may believe in renting a home and never buying a home. Our "goals" should determine how much we save and then how we invest those savings.

Shilpa's choice

But all of us have a "consumption basket" - we all consume things and, as long as we live, will increasingly consume things. The price we pay for our consumption basket is likely to increase over time - the effects of inflation.

Let's take the example of Shilpa, a typical consumer and see how thecost of her consumption basket has changed over time (Table 2). The start year is assumed as 1990. That is just before the Great Indian Reforms of in 1991 when most services or products were provided by either government monopolies or by a few licensed private sector cartels.

Table 2: Shilpa' s cost of living per annum
CONSUMER BASKET 1990* 2000 2010 2011
Food and personal care (Grocery bill) 10,167 20,000 37,500 42,500
Taxis / Trains / Local air travel 3,696 8,750 11,250 15,000
Clothes, shoes 964 2,500 3,750 4,250
Going out (Recreation and Cultural activities) 402 1,250 4,500 6,250
Rent / Accommodation cost 10,000 40,000 70,000 80,000
Electricity 2,000 5,000 8,000 9,000
Telephone / Mobile phone bills 3,500 6,500 9,000 10,000
Medical expenses 2,000 5,000 6,500 8,000
Education 500 2,000 3,000 3,000
Electronic items 880 2,500 18,750 22,500
Holidays (Hotels and Restaurants) 8,805 25,000 50,000 62,500
TOTAL SPENDING PER ANNUM 42,914 118,500 222,250 263,000

Fully aware the costs of enjoying her consumption basket over time will increase; Shilpa knew she had to invest her savings.

For arguments sake let's assume that Shilpa had 3 extreme choices:

  1. Invest all her savings in gold,
  2. Invest all her savings in the stock market via the BSE-30 Index,
  3. Invest all her savings in a Fixed Deposit with a PSU Bank.
Table 3: You need less of "BSE-30 Index money' and "gold money" and
more of your "FD money" to enjoy your consumption basket.
CONSUMER BASKET 1990 2000 2010 2011
TOTAL SPENDING PER ANNUM 42,914 118,500 222,250 263,000
Price of gold, INR/10 grammes 2,145 4,012 17,940 23,544
Units ( Grams) of gold to consume my basket 200 295 124 112
BSE SENSEX 942 4,606 18,207 17,778
Unitsof BSE-30 Index to consume my basket 46 26 12 15
Fixed Deposit Basket Index Value (Value of initial investment Jan 1, 1990 =1000) (SBI 1 Year Deposit Rate)* 1,064 2,220 3,550 3,769
Unitsof FD Basket to consume my basket 40 53 63 70

* Quarterly compounding and Tax rate on Fixed Deposit assumed to be 30%

As Table 3 indicates, the annual cost of her consumption basket in 2011 is Rs 263,000 v/s Rs 42,194 in 1990 - that is an increase of 613% in 21 years, an average price increase of 9% per year over the past 21 years.

If Shilpa could use gold to pay for her consumption, she would have needed 200 grammes of gold in 1990. To maintain her "consumption basket" in 2011 she would need only 112 grammes of gold. This is so because the price of gold has surged by 1,098% over that same 21 year time period - an average rate of return of 12% per year for the past 21 years. This is higher than the increase of 9% in the prices of the items in Shilpa's consumption basket.

If Shilpa could pay for her consumption with units of "BSE 30 Index" then she would have needed 46 baskets of the BSE-30 Index in 1990. To maintain her "consumption basket" in 2011, she would need only 15 baskets of the BSE-30 Index. This is because the BSE-30 Index has surged by 1,888% over that same 21 year time period - an average rate of return of 15% per year for the past 21 years. This is higher than the increase of 9% in the prices of the items in Shilpa's consumption basket.

If Shilpa could pay for her consumption with units of Fixed Deposits or "FDs" then she would have needed 40 baskets of the FDs in 1990. To maintain her "consumption basket" in 2011, she would need a larger number of 70 baskets of the FDs. This is because, while the FDs may have given an average return of 6% after tax, they are below the nearly 9% increase in the prices of goods that Shilpa consumes. This is lower than the increase of 9% in the prices of the items in Shilpa's consumption basket.

Note the risks

But before you go rushing to buy equity shares or gold, note that both these asset classes can be in the dumps for a long period of time. Or, conversely, can also be "at peaks" for a short period of time.

Changes in tax laws will also influence where people could save. If investing in FD's was to become tax free, then maybe Indians like Shilpa would see the benefit of investing in them.

Similarly, gold may now attract an import tax and a wealth tax.

Shilpa's consumption basket could change.

But the biggest risk is, in my opinion, is not diversifying the surplus savings we have into a range of instruments that can give you a steady, decent return and an opportunity to live through some tough times.

Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt. Ltd and Quantum Asset Management Company Pvt. Ltd. The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The author, Equitymaster, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site. To write to Ajit, please click here.

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