Debt Instrument (Fixed Deposits) vs Equity Return comparison

POSTED BY parag ON May 15, 2012 1:03 pm COMMENTS (16)

I don’t have much equity exposure may be 5% of my portfolio will be direct equity exposure. Every one I meet advice me to increase Equity allocation (I am 33 years old) and has got 0 debt, own house etc.

So the question is why do you guys advocate Equity exposure when the fact is that over a period of time, even Fixed Deposit with interest accumulation gives comparable result though a bit less mainly owing to Tax implications but without any risks.

To illustrate my point lets compare present 9.25% fixed deposits in nationalised banks like Bank Of India and HDFC Top 200 which I believe is most common choice.

Fixed Deposit (with interest) annualized
5 Year : 11.60%
10 Year : 15.00%
16 Year : 21.00%

HDFC Top 200 G (Source : http://valueresearchonline.com/funds/newsnapshot.asp?schemecode=104)
5 Year : 10.15%
10 Year : NA
16 Year (since launch) : 22.00%

As you can see from above it’s debatable whether the risks are worth 2-3% extra (after tax) that you may gain (what if DTC removes tax inequlity)? Also do you honestly believe that past performance of Indian economy (95-2005) can be repeated? I have severe doubts about the second one.

Please discuss… The purpose of the post is to learn more about value investing and think more about my own options.

16 replies on this article “Debt Instrument (Fixed Deposits) vs Equity Return comparison”

  1. Jig says:

    hello Mr Parag,
    I think we both are in the same boat. 🙂
    Please go through the below thread
    http://localhost/jagoforum2/online-vs-offline-sip-in-mutual-funds/3524/

    I am also using the same kotak bank and kotak securities for inveesetment. Just for information , if convenience is your take, it is the best way of investing in securities as well as MF/SIP all together. Very smooth platform and easy to operate. ( Prefering for long term investor and not trading).

    In above thread, see the last comment by me , which i would like to answered by some of expert guys who really cant give detailed view on charges.

    Thanks & Regards
    keep sharing
    Jig

    1. parag says:

      Thanks Jig 🙂

  2. parag says:

    Guys thanks very much for replying :). Now that I am convinced I would look to alter my portfolio. I have huge FDs locked in for 10 years or more, so I am not going to upset those, but luckily I have good savings coming in every month :). Over time my investment portfolio will be better. I know market is down now, so it’s precisely good time for investment 🙂

    Now the question is what’s the best way to do SIP ? Also what should I do with large lump sum amounts that may come up periodically ? (I am in Software Business and apart from usual remuneration, I do receive large lump sum amount every couple of months.

    I have an account in Kotak + Kotak securities and they can enable SIP but I am not sure if that’s the best way to do it ? What are the charges that I may incur on mutual fund investments ?

    Finally what Funds do you guys suggest for me ? Since I have big deposits, I am assuming I just have to go with Growth and Equity funds (no balanced etc)?

  3. Jig says:

    Sorry but that is PARAG , typo mistake 🙁

  4. Jig says:

    yeah ,
    and i am that guy who was confused. After reading all i was supposed to reply that this guy ( Amit ) is talking about yield and not the annualised return. 🙂 ( but well it is just informed by very loving ,caring guy Ashal)

    I urge Amit to must go with this http://localhost/jagoforum2/mf-yield-calculation/1511/

    I got amazing knowledge by such thread. and so would like to share

    Thanks
    Regards

    1. Dear Jig, thanks for such praising words.

      thanks

      Ashal

  5. Dear Parag, let me also try to answer you what others tried.

    From your own query – 9.25% is the coupon rate of that bank FD which ‘ll has qtly compounding.

    Now the nos. posted out by you –

    Fixed Deposit (with interest) annualized
    5 Year : 11.60%
    10 Year : 15.00%
    16 Year : 21.00%

    are the yield or should I say simple interest calculation & not the compounding one. That’s why after 16Y, FD is 4L+ but that HDFC Top 200 MF is 24L+.

    This type of question was discussed some time ago here in this forum & just like you the person who posted the query was confusing between annualized interest & the annualized yield.

    Please check on your own the qtly compounding of 9.25% yly rate means 1L Rs. ‘ll become 4.31L Rs. after 16Y.

    Now here Interest is 3.31L Rs. Now back calculate from the simple interest formula

    Interest = (Principal * Rate * Time) / 100

    So from the above equation Rate = (Interest *100) / (Principal * Time) = (331000 *100) / (100000 * 16) = 20.6875 (the difference in calculation is due to round off of amount 431000)

    Hope the above calculation is able to point out your mistake in your calculation.

    Thanks

    Ashal

  6. I think there is a terminology difference in the annualized I used and what Value Research online does.

    TO keep it simple lets call the growth rate as CAGR (Compounded Annual Growth Rate). The 22% you see is the return achieved every year for 16 years.So:

    CAGR for Bank FD = 9.25%
    In Excel put =FV(9.25%,16,0,-100000,1). Final value is 411,853.85

    CAGR for HDFC Top 200 = 22%
    In Excel put =FV(22%,16,0,-100000,1). Final value is 2,408,559.01

    If you want to invoke the compounding formula learnt in school here it is:
    Value of FD = 1 Lac * (1.0925)^16 and
    Value of MF = 1 Lac * (1.22)^16
    Go figure the final values!

    Lets do some back of envelope calculations called Rule of 72. If you divide 72 by the interest rate that will tell the number of years for an investment to double.

    For FD: 72/9 = 8 years. Your investment doubles approximately 8 years which is why after 16 years you have 2 doubling cycles => 1 lac to 2 lac to 4 lac.

    For FD: 72/21 = 3.5 years. Your investment doubles approximately 3.5 years which is why after 16 years you have 4.5 doubling cycles => 1 lac to 2 lac to 4 lac to 8 lac to 16 lac in 4 cycles and another half cycle will add 8 lacs = 24 lacs. See the power of compounding?

    Do it any way – FD returns left alone lags way way behind. Even under the going to be proposed [if ever comes] EET regime, what I meant is the LTCG taxes will be way lower (instead of now being zero) so the returns will come down say by 4-5 lacs on the 24 lacs which is still 5 times or 500% the returns in a FD.

    You need to change your mindset on Debt.

  7. Parag

    A FD of 9.5% return is always 9.5% return in any time frame . See the return of any debt product along with market returns . Note last few years market data is uncommon .

    I suggest you grab my book copy and read the 3rd chapter on Equity and Debt, seems like I wrote it just for you 🙂 : http://www.flipkart.com/books/9380200415?affid=INManish2

    1. parag says:

      Thanks Manish, I will be ordering it today 🙂

  8. Parag – You missed 2 major points that make significant difference to the final corpus.

    1) You are making incorrect calculation/comparison. Any amount less than 1 year is usually annualized but you need to compound returns over 1 year (vice versa annualize the MF returns). Thus a 9.25% FD will have a compounded growth rate of 9.25% per year and that’s all. The 10 and 15 year return you see for HDFC Top 200 and all other Mutual Funds is the COMPOUNDED RETURN.

    1 lac invested in FD for 16 years at 9.25% = 4.11 Lacs
    1 lac invested in HDFC Top 200 for 16 years at 22.00% = 24.08 Lacs

    [Alternately if I crudely annualize HDFC Top 200 returns the gain is 23 lacs over 16 years. Gain per year = 1.43 lacs ==> The annual return on HDFC Top 200 = 143% versus FD 21%. See the difference?)

    2) You did not consider taxation at all. FD interest must be added to your income and be taxed. Thus if one invests in a FD and renew it after 5 or 10 years they may
    a) Get taxed on the gains
    b) Perhaps get a lower reinvestment rate

    In the case above assuming someone booked a 9.25% for 10 years (MAXIMUM FD tenure usually) took the after tax proceeds and reinvested at 9.25% their corpus would be:

    10% Bracket: 387671
    20% Bracket: 363489
    30% Bracket: 339307

    Even if MF returns will be taxed it will still be at a lower tax slab than FD at any point. No economy is dumb to tax LTCG at higher rates.

    Will we sustain the growth? Does investing in Debt alone make sense? All of these have been analyzed many many times over in this forum. Check this link below:
    http://localhost/jagoforum2/sip-vs-ppf/2729/

    At the end of the day the 100% Debt holder will lose the inflation and financial planning game. There is no second chance in finance for time is a powerful tool. Any time lost is lost. At 33 I would say your exposure to equity is low. It is still not too late to start financial planning (not too early either).

    Revert with any more clarifications you will need.

    1. parag says:

      Now this is totally confusing ? Value Research clearly states 22% is annualized. Can you please elaborate on that? 1 lac in 16 years = 24 lacs sounds to good to be true. I may even say it’s insane returns :). Please share in details how you came to these figures.

      Regards to taxation, I was implying the new “EET” which will look to tax at time of redemption. Again I am not a tax consultant, just trying to judge what-if scenarios here as a retail investor.

  9. BanyanFA says:

    Parag,
    You have a very valid point – in the current scenario. However, it is important to note that if you are looking out in the market, no bank shall provide you FD greater than 10 year maturity. Plus, most banks interest rate would be around 8.5 – 9% range for 10 year horizon.

    If you are looking out for longer maturity periods, then the only available option with you is PPF / PF which are providing approx 8.5% return – tends to change every year.

    Would that impact your calculations now ?

    Regards
    BanyanFA

    1. parag says:

      @BanyanFA – Thanks for your reply. I checked with Bank of India, they can even take 15 years Fixed Deposit at same rate : http://bankofindia.com/rupeetermdeposit.aspx

      1. BanyanFA says:

        Parag,
        Even though BOI page mentions 10 years and above, if you would call them, they won’t take a FD request for 10 years plus duration.

        1. parag says:

          Just confirmed from my friend in BOI, they can take 15 years deposit, but it is irrelevant now that I know the difference in calculations 🙂

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