As we often see, that dreams do come true. Samar after years of hard work in engineering found a job with a multinational company. As the date of his first salary came near, Samar’s father sat down with him to offer some financial advice. His father had worked his entire life in a small private company, raised two children and in next 5 years his retirement was due. His golden words of advice were, ‘start investing your money into fixed deposits.’ Samar was thinking more in line with mutual funds. Words around the office were mutual funds provide higher returns than fixed deposits, they are tax efficient, plus can be withdrawn anytime if the relevant lock in period is over. Samar argued that his father is very conservative while he is more aggressive to take risks.
If sports can be used as a metaphor out here, then Samar’s father had grown up watching Sunil Gavaskar who batted slowly but surely. While, Samar had grown up watching Sachin Tendulkar who batted with more flamboyance and risk. Both have been legends in their time. In a way, even fixed deposits were a great option in a certain period of time and mutual funds also makes a lot of sense in a certain period of time.
During the argument, Samar noticed that his father has parked a substantial amount of his life’s earnings into fixed deposits. When a student of engineering background sees some numbers, he is quick to calculate. He could see, how much investment returns on a compounded basis his father lost by simply putting in fixed deposits. So now, there was a whole new argument to move that money into mutual fund as well. However, is the argument really valid?
First things first, most people think that mutual funds only invest in shares of companies. That’s why they are tremendously risky. It’s common to see that there are other forms of mutual funds too, like debt, gold and even real estate now. Hence, it becomes very important to know when money is being shifted from fixed deposits, it’s not necessary to have an exposure into equity. Other options are available too.
Asset allocation becomes the primary need. For that, goals need to be properly defined. If money is being saved and invested, it is working for you. There should be a pay off. If money is being invested without a future use then it will lose it’s value. Something like Public Provident Funds (PPF). Around 3/4ths of PPF are withdrawn not by the people who invested, but by their nominees after their death. Reason – Since money in PPF was invested just to save tax. Hence, putting a goal becomes the most important aspect before investing that money. If the goal is far into the future, then Samar’s argument of having a higher exposure to equity sounds valid. However, if the goal is in near term, say around 2-3 years then money can be kept into fixed deposits or some debt based mutual funds which will ensure stability until utilised.
While Samar was convincing his father of withdrawing money from fixed deposit, he said ‘interest rates are going down! That’s an enough reason.’ Off lately, we are being a party to such comments
from so called market experts. They often add an explanation which sounds music to a growth hungry country, ‘India is growing under the leadership of it’s current Prime Minister, interest rates are going down and investing in businesses is better than keeping that money in banks.’
Most of the times, people often end up trying to rationalise it, like whether it is right or wrong. Instead, focus should be to personalise, whether it makes sense for my money or not.
While looking at asset allocation, fixed deposits form a part of ‘Debt’ bracket. Since, they have received a cult like phenomena, often investors overlook debt based mutual funds. Since, mutual funds are always seen with risk plus growth, fixed deposits have always stole the limelight when the very first thought strikes to save money. Below mentioned are a few characteristics as to how Debt Mutual Funds can be considered as an alternative to fixed deposits.
Debt based Mutual Funds
- Higher Returns: On average, debt mutual funds may have a potential to provide better return than fixed deposits.
- Tax Efficient : Comparatively Debt Mutual Funds are tax efficient. They are not completely tax free but if sold after 3 years of investment they are subjected to taxation of long term capital gains. Indexation benefits are available in this scenario which are lined to inflation. Hence, the tax will be subjected to gains minus inflation resulting in lesser tax. If Sold within 3 years the gains are added to existing income and taxed at the marginal rate
- No Tax Deducted at Source (TDS) : In case of fixed deposits, TDS is deducted on yearly basis whether interest is paid or accrued. This is not applicable in terms of debt mutual funds.
- No Lock in period : In mutual funds, there is no lock in period as such. Exit loads apply on some schemes while some are even available without exit loads. However, in fixed deposits there is a definite lock in period which is to be engaged in while creating one.
- Partial Withdrawal : In debt mutual funds, an investor can redeem units partially and use that money. While in the case of fixed deposits, an investor needs to redeem it fully. Partial withdrawal is not available.
- Tax Outflow : When an investor chooses to have cumulative interest on fixed deposits, he still needs to pay tax on interest accrued. It looks like a better option in the long run but tax has to be paid for interest money which is not received currently. This puts additional tax burden and doesn’t make it an efficient investment decision. No such problems arise in case of debt mutual funds.
Money invested in just one asset class, increases the risk of concentration (such a risk emerges when few investment instruments are used). Hence, a diversified asset allocation should be adopted based on the goals and risk profile of an investor.
Equity as an asset class, in it’s unique ways provides for participation in the long term success of a business. When businesses boom, jobs are created and country as a whole flourishes. It helps beat inflation too. The most respected investor in the world, Mr. Warren Buffet quotes participating in equity as ‘If a business does well, stock (shares) eventually follows.’
Coming back to our argument of “because interest rates are going down’, doesn’t make it a valid argument to invest into mutual funds. As a thumb rule, asset allocation must be taken into consideration along with goals and risk profile of an investor. Hence, an investor needs to sit with his advisor and clearly chalk out the end use of that investment. Accordingly, money should be allocated among different asset classes. At the end of the day, when money is working hard for us then we should also give it a great proper direction.
To sum it all up, personalise your investment and look into what works for you and what doesn’t. Once that is achieved, rationalising investment will give better fruits. The reverse way will yield sour grapes. Just think about it, if that fox had personalised his decision of grapes then he wouldn’t have gone for something which is beyond his jump. It’s just that fox tried to rationalise it thinking grapes would quench his hunger, he remained hungry and in the end said grapes are sour. Well, context of story is not really intended to those who had a sour experience in the capital markets. Just thinking.
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– Jinay Savla