Karmayog Knowledge Academy
Stock markets appear weak, there are concerns regarding monsoon, the crisis at Greece, industrial growth in India, fall in Chinese markets. The interest rates are likely to move down. In such a scenario, some investors are considering to invest in fixed deposits. The logic is to avoid the risk of equity markets and to lock-in the current high rates before the interest rates fall.
If you are also thinking on similar lines, please wait before you jump the bandwagon and start investing in fixed deposits. There are seven common mistakes that investors tend to make. These are:
1. Changing the allocation from one asset class to another without a solid reason
2. Not being able to match the maturity of the deposit with your goal horizon
3. Dividing money across many deposits to avoid TDS, assuming that the interest without TDS is tax-free
4. Not diversifying across companies and industries
5. Confusing between “fixed income” and “guaranteed return”
6. Chasing high returns
7. Investing in someone else’s name (parents) to get a higher rate available in case of senior citizens
The first question should be: “Why?” Why should one do what one wants to do is a crucial question one must consider before taking any investment decision. Someone may argue that you started the article with arguments favouring fixed deposits. Let me clarify: these are not my arguments and these are not appropriate to form an investment strategy for an amateur investor – someone who is not full-time involved in the business of investing.
The answer to the “why” is not about the view one has of the external environment, but whether an investment avenue is suitable for one as part of a long-term, well thought out plan. So what is a long-term plan? A long-term plan is to allocate your money across various investment avenues and periodically track in order to achieve various financial goals. The plan also takes your financial situation, your limitations and risk appetite into consideration.
Changing the allocation to the investments without any changes in your own situation is a mistake one would be better off avoiding.
One aspect of the planning is to classifying the goals into short, medium and long-term. The long-term goals are vulnerable to the risk of inflation. The money required to fund your long-term goals might rise a lot due to the fact that prices of various items rise over the years. Fixed income instruments may not be able to deliver higher than inflation returns over a period of time. This means, there is a danger that you may fall short of the amount required to finance your long-term goals. Do not change your investments, if your goals and your situations have not.
The other issue with fixed deposits is that these have a specified maturity period. It would be fine if you could find fixed deposits that exactly match your goal period. In all the other cases, you will have to break your deposit before maturity or invest the proceeds if the goal is still away in future when the deposit matures.
Some people divide their investments across various fixed deposits to avoid TDS. There is a difference between tax and TDS. While the former is payable by the earner of the income, the latter is deducted at source by the payer of the income. There are provisions in the Income Tax Act according to which the limits of such deductions are decided. In order to avoid TDS, many investors invest their money across many banks in small amounts. Now, just by dividing the fixed deposits, one can only avoid TDS, but not the tax. While deducting the TDS is the responsibility of the payer of interest, the tax liability is always on the earner of the interest income.
Also Read: TDS - Too Tedious to decipher?
At the same time, dividing money across many banks only adds to the administrative inconvenience.
While dividing money across various companies in itself may not be a bad idea, the reason behind the same must be clear. If you are spreading your investments to save TDS, it is not a good idea; however, doing so for the purpose of diversification across various companies and across industries is a prudent investment strategy. A note of caution here: diversification has to be across different companies and different industries. Diversifying across companies within the same industry is insufficient.
Unfortunately, there are not many options available in this space. Most of the fixed deposits are from NBFC and real estate sectors. Incidentally, both these sectors are considered to be riskier than most other businesses. Be careful. You may not want to take on a very high risk of default just in the lure of high interest rates.
It is important to remember that fixed deposits are fixed income instruments and not guaranteed return instruments. First of all, fixed deposits are unsecured instruments unlike many debentures, which could be secured by a charge on some assets of the company. Second, the returns are fixed, but not guaranteed. The risk of default is ever present.
It is important to remember that the fixed deposits that promise to pay higher interest rates are inherently risky. The only reason why such rates are offered is that the issuer is unable to get good rate from the market. In order to be able to pay you the promised interest rate, the issuer has to earn more than the rate offered. Higher the expected rate of earning, lower is the safety of your money – not just the interest, but also the principal. In the bullish times, the company may be able to service the obligations. However, when the economy slows down, earning very high rates becomes difficult even for the best of the companies. In such times, the companies that have raised money by promising high interest rates, go under pressure and start defaulting.
The last mistake some investors make is to invest the money in the name of their parents, as many banks offer between 0.25% to 0.50% extra interest to senior citizens. While earning extra return is always a good idea, shifting the ownership of the money could complicate things at a later date.
Be careful when you invest your money in fixed deposits. Please understand the possible mistakes and avoid those.
The views expressed are his personal views.