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How Fixed Deposits Can Help You Plan for the Future

01 December 20236 mins read by Angel One
Fixed deposits offer moderate but guaranteed returns and thus act as a stabilising component in your portfolio. Read more on how these investments can help you secure your finances!
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Fixed deposits, or FDs, have been a tried and tested instrument in India to preserve and grow wealth at moderate rates. In the post-COVID era, when market volatility is high and may often be unexpected, creating a well-diversified investment portfolio with FDs can be very useful. This is because the FDs serve as a cornerstone in the portfolio, offering stability and security. 

In this context, let us go over some of the distinct advantages, as well as certain limitations of fixed deposits.

Important Features of Fixed Deposits

  1. Fixed Interest Rates FDs offer a fixed rate of interest which helps in the predictability of the returns.
  2. Higher Rates – The rate of return is usually much higher than the average rates offered for savings accounts in a bank.
  3. Guaranteed Returns – The returns from FDs are guaranteed by the banks, regardless of the conditions in the market.
  4. Liquidity Issues – Usually FDs have a minimum lock-in period. However, many FDs nowadays allow you to withdraw your funds after a very short period of time, but with a penalty.
  5. No trading – Unlike stocks, bonds and ETFs, FDs cannot be sold in a  market.
  6. Tax Benefits – Tax-saving FDs offer deductions under Section 80C.
  7. Deposit Insurance – All the FDs of banks are covered under the depsoit insurance guarantee scheme, under which, deposited amounts of up to ₹5 lakh is insured and guaranteed, covering both principal and interest. However, amounts beyond ₹5 lakh are not guaranteed in case the bank goes bankrupt.
  8. Loans against FDs – Although you may have problems in withdrawing a lump sum money from your FD, you can take a loan against that FD for your liquidity needs.

Overall, the guarantee of the safety of the deposit, the guaranteed fixed returns and those returns being higher than the average savings deposits are some of the most attractive features of the fixed deposit. 

Advantages of Fixed Deposits in Portfolio Diversification

  • Stability and Security:

FDs provide a stable, predictable return on investment, shielded from market volatility. The principal amount remains secure, offering peace of mind to risk-averse investors.

  • Guaranteed Returns:

With pre-determined interest rates, FDs assure fixed returns at maturity. This predictability makes them an attractive option for planning future cash flows.

  • Diversification Benefits:

Including FDs in a portfolio adds balance by offsetting riskier investments like stocks or mutual funds. This diversification hedges against market fluctuations.

  • Liquidity and Accessibility:

While FDs have a fixed tenure, many financial institutions offer premature withdrawal options or loans against FDs, ensuring access to funds in times of need.

  • Varied Tenure and Interest Options:

FDs offer flexible tenure options, ranging from a few months to several years. Institutions also provide different interest payout frequencies, catering to diverse financial needs. You can thus arrange your FDs with varied interests and maturities in a way that matches the various financial goals or requirements that you may have from time to time in the coming years.

  • Tax Benefits:

Under Section 80C of the Income Tax Act, investments in certain FDs can qualify for tax deductions, thereby reducing the tax burden on investors.

Limitations of Fixed Deposits in Portfolio Building

  • Interest Rate Risk:

FD interest rates are fixed at the time of investment. In a fluctuating market, this fixed rate might not keep pace with inflation, potentially impacting real returns.

  • Lack of Flexibility:

Once invested, the funds are locked in for a predetermined tenure. Premature withdrawals might incur penalties or reduced interest rates, affecting the overall returns.

  • Opportunity Cost:

While FDs offer security, their conservative nature might lead to missed opportunities for higher returns available through more dynamic investment avenues like equities or real estate.

How To Use Fixed Deposits in Personal Finance?

Your personal financial strategy depends on the level of returns you need, the timeline of your investments and the amount of risk you are willing to face among other factors. Let us review the utility of an FD based on some key contexts.

Who Is a Fixed Deposit Suitable for?

Fixed deposits are suited for those who:

  1. Have a predictable income in the upcoming years and are comfortable with locking their money in a fixed deposit. In other words, the investor should be okay with low liquidity.
  2. Have an appetite for low risk and moderate returns. In other words, they should be able to accept a moderate rate of return in order to reduce the risk to their portfolio to a minimum. When the market for stocks or bonds is experiencing a bullish phase, they should be able to stay invested. 

What Is the Level of Risk in Fixed Deposit?

The principal and the interest of the FD are both guaranteed by the bank. You can therefore look at an FD as a low-risk instrument and use it to act as a balancing force or an anchor in your portfolio. The low risk of the FD can then offset the risk from the high-risk instruments in your portfolio such as equity or equity funds. 

However, there are still certain risks associated with FDs:

  1. Liquidity risk – In case the FD has a lock-in period or a penalty for early withdrawals, then you may be unable to withdraw the money for an extended period of time. You basically will have to part with a large amount of money for a period of a few years and wait until the FD matures.
  2. Risk of inflation – The rate of return from an FD is fixed. Therefore, if the rate of inflation exceeds the rate of return or interest of the FD, then there is no way for that FD to beat the inflation.
  3. Risk of bankruptcy – Another risk that FDs have is the risk of the banks going bankrupt. The risk is partially reduced by the mandatory deposit insurance guarantee of up to ₹5 lakh covering both principal and interest. 

How Do Fixed Deposits Compare to Other Investments?

Fixed Deposits vs Stocks and Derivatives

Stocks and derivatives are some of the most risky assets available in the market. Therefore, if you are new to personal finance, you should keep stock and derivatives trading to a minimum. However, if you want returns beyond 10% to 15% then you may consider investing or trading in stocks and derivatives. Compared to them, fixed deposits are low-risk investment tools that give moderate returns of 5% to 8%, regardless of market conditions. 

Fixed Deposits vs Mutual Funds

Mutual funds are of various types. A fund may be investing in stocks, bonds, or commodities. Based on the proportion of different assets that the funds invest in, the risk and returns of the fund may vary. Therefore, you need to evaluate the overall risk and return associated with the investment in order to understand which one you should invest in and in what proportion. In such a situation, you may take the help of an FD calculator and a mutual fund returns calculator to assess the returns in the long run.

However, there are certain advantages that an FD has over a mutual fund.

  1. An FD does not have a major expense ratio, unlike some of the actively managed mutual funds.
  2. The returns from mutual funds are subject to market risks and volatility, unlike the guaranteed returns of an FD.

Both FDs and mutual funds may or may not have a lock-in period and penalties for early withdrawals.

Fixed Deposits vs Bonds

Bonds may offer guaranteed returns at a fixed rate if they are fixed-rate bonds. The rate of return may vary if it is a floating-rate bond. This is in contrast with FDs which have a fixed rate of return. 

However, bonds not only give returns from the interest paid, but also offer capital gains from an increase in the price of the bonds. However, they also run the risk of depreciation in value if the interest rates in the market increase too much. A fixed deposit does not have this issue as they cannot be bought or sold in a market.

Fixed Deposit vs Pension Fund and Insurance

Fixed deposits, pension funds and insurance are popular investment avenues. But while both pension funds and insurance are meant to help you under a very specific set of circumstances, such as health issue or old age, an FD can be redeemed whenever you want, subject to any lock-in periods. 

How To Diversify Beyond Fixed Deposits?

When it comes to diversifying beyond FDs, it is best that you take a dynamic approach. This means, in your initial years, you can place a moderate portion of your investment in an FD and use the rest to earn high returns from stocks and derivatives and learn more about various investment strategies. Also, you can invest in a pension fund and insurance at this stage. 

Over time, as your early investments pay off, you may consider transferring the money to more and more FDs, especially if you are suspecting a bear market. Finally when your pension fund becomes redeemable, you can choose to then invest the redeemed money and a larger chunk of your portfolio in risk-free instruments like FDs.

Conclusion

Fixed deposits, with their stability and predictability, play a pivotal role in a diversified investment portfolio. While their limitations must be acknowledged, the security and guaranteed returns they offer make them an essential component in financial planning.

 

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