Are safe investments sufficient to fulfil your life goals?
"Let's invest the surplus money in a fixed deposit." How many times have you thought about this? Well, you are not the only one. Many people prefer investing only in debt and fixed income instruments, as these are generally less risky as compared to other asset classes such as equity and gold. Many feel that it is extremely important to protect their portfolio from market volatility at all times irrespective of other factors. Although, it cannot be denied that debt instruments restrict your downside risks they might not help you meet your financial goals (such as retirement, children's education etc.) only by themselves.
The following points will help you understand this in detail:
Now, does all this mean that investments in debt instruments must be avoided and one should only invest in equities? Definitely not! It is important for you to understand that your portfolio must well-diversified keeping in mind your asset allocation and risk appetite. Asset allocation is an investment strategy that helps to define a road map for your investment portfolio, with appropriate diversification across asset classes. Under ideal circumstances, investors who have an aggressive risk appetite and whose objective is to achieve long term capital appreciation can invest upto 70% in risky assets such as equities and related instruments, and the remaining 30% in safer asset classes such as debt and cash instruments. Moderate investors, who aim at providing some stability to their portfolio along with capital growth, may invest upto 60% in equities and balance (40%) in debt and cash. Conservative investors', who prioritize the protection of their capital, can invest upto 70% in debt and cash, while the rest can be diversified by investing in quality equity instruments. However, before you follow this asset allocation pattern, it is necessary to consider factors such as age, income, expenses, assets, liabilities, time horizon and willingness to take risk.
- Inflation beating returns
Before you invest in any instrument it is necessary to consider the 'real returns' generated by it. 'Real returns' is nothing but excess nominal returns over and above the inflation. For example, if your investments generate 10% returns and the rate of inflation is 8%, your real returns are 2%. Although fixed interest rate bearing instruments generate steady returns, real rate of returns generated by them may be negative if rate of inflation is higher than the interest rates.
These are 'low risk-low return' investments which are ideal for providing safety rather than capital appreciation. Equities, on the other hand, although volatile have the ability to not only counter inflation but also create wealth for the investor over the long term.
Rate of interest on various debt instruments
(*effective interest rate per annum)
|Public Provident Fund
|National Saving Certificate (5 years)
|National Saving Certificate (10 years)
||8.50% - 9.00% p.a.
|Post Office Time Deposit (5 years)
(** compounded quarterly, paid annually)
(Source: PersonalFN Research)
The debt instruments shown in the above table at present generate returns in the range of 8.50% - 9.00% for a general citizen. However, taking the Consumer Price Inflation (CPI) into account, the real rate of returns generated by these instruments will fall in the range of 0.70% - 1.20%, which may not be sufficient to achieve all your long term goals.
- Tax implication
Income from debt instruments such as fixed deposits has to be added to your taxable income and is taxed as per your tax bracket. If you fall in the 30% bracket, the return earned on your fixed deposit gets lowered by that much amount. Thus the actual returns generated, might fall short in your endeavour towards wealth creation. Moreover, the recent budget has reduced the tax efficiency of even debt mutual funds. In case of mutual funds other than equity oriented funds, the rate of tax on Long Term Capital Gain (LTCG) has been increased from 10.0% to 20.0% on transfer of units of such funds. Moreover, the period of holding in respect of such funds (to be categorised as LTCG) has been increased from 12 months to 36 months. These new provisions place bank fixed deposits and debt mutual funds almost parallel. And by doing so, PersonalFN believes going forward Fixed Maturity Plans (FMPs) will not continue to offer double-indexation benefit (as they did) if the investment tenure is lower than 36 months.
Conversely, in case of equities, the period of holding (to be categorised as LTCG) is only 12 months. Moreover, income arising on the sale of shares of companies and equity oriented mutual funds are exempt from LTCG.
PersonalFN is of the view that constructing a financial plan and adopting a prudent asset allocation pattern will enable you to meet all your financial goals in a structured and planned manner. Since every individual may not have the time and expertise to undertake these processes on their own, it will be wise to take the help of an experienced financial planner so as to meet your objectives in a simple way.
PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.
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