POSTED BY January 3, 2013 11:34 pm COMMENTS (10)

ONLocking away money in an FD for 10 years is giving an yield of 12.63%, the higher yield is due to the magic of ‘compounding’ in effect every quarter.

On top of that there is no tax deducted on interest earned as NR customer unlike domestic FDs.

With that extra benefit of saving on tax as NR customer, Does such no-risk yeild in FDs not compare favourably to MFs (or anything else) where in addition to risk of losing the capital (may be very unlikely), there is also a chance of returns being less than 12.63%? Is 12.63% not a good enough return (with no other hassles), consistent over/for 10 years that we can subcribe to?

lets look at compounding alone and not the nature of investment

Say you invest rs. X at some % interest rate (doesnt matter what) for the first few years (some fix it at 3y some at 5y) the diffrence between X and Y where Y is maturity amt is not very big.

as the years roll by Y becomes much greater than X (at 10 years the % difference is 86% and at 12y 96%). This % difference is small (a relative term of course, 28% for 4 years) so effect of compounding is small This has nothing to do with FDs or MF

longer the better effect of compounding is independent of investment

for goals less then 5 years away returns are not important, neither is inflation (it is negative compounding), safety from loss of capital is important, taxes are importan

for goals more than 5 years away returns are important BECAUSE inflation is important. So I have to bear the risk of volatility so that the AVERAGE return is higher than inflation.

If this is not the case I lose purchasing power

If I am invested in a FD for a long term I am taking no risk in terms of volatility but I am taking a risk because my returns are likely to be comparable to inflation and therefore I can either barely fund my goal or simply cannot.

This is not debate about FD or MF. It is always FD (or other dent instruments) AND MF

for short term goals debt has higher % than equity (small or zero)

and equity has higher% for long term goals. This % has to decrease well before the goal date (2-3 years before)

You say:

when compounding is applied every quarter, they still could give better returns in-spite of their low yearly rates is my understanding.

mathematically this is true. But depends on the interest rate. if annual comp product has higher interest rate then overall returns will be higher for that.

The take home message as I see it is for long term investing you must a good part of the investment in products which will give returns well above the inflation rate so that the average or net rate of interest is at least a little above inflation. Equity investing is the only product which can do this, If this does not happen the goal will not be achieved

“FD are okay for less than 5 years since effect of compounding is minimal” – do you mean to say, the effect of compounding is not great in case of FDs, so better to go for less than 5 yr FDs? How is that, please explain a bit more what you meant?

I thought by its very definition compounding is good – the longer the better. Especially in case of FDs (not sure about others – is it yearly there?), when compounding is applied every quarter, they still could give better returns in-spite of their low yearly rates is my understanding.

I like your realistic answer when you say in case of others, the returns are never guaranteed and it is up to us to have review every year and to do necessary balancing.

This is an answer I gave to another question but is suitable to yours:

FD or MFs: The answer depends on when you need the money

risk and volatility should not be confused.

Risk is loss of capital or loss of purchasing power. Volatility is fluctuating returns

SIP in the short term less than 5 years is risk in terms of loss of capital due to high volatility

A FD has no volatility but is risky in terms of loss of purchasing power since it will not be able to beat inflation.comfortably, even at 9% (tax free lets say) Longer the FD duration higher is the risk

SIP in equity for more the 5 years, the volatility in returns will be there but the risk comes down quite a bit since the average return has historically been well above inflation and therefore SIP is the preferred choice (as a major component not only part) for long term investments

In fact above 10 years risk of loss of capital comes down dramatically

at 15 years it is historically zero!

Of course one should not all eggs in one basket, have proper asset allocation and rebalance according to risk profile and if necessary book profits from time to time.

FD are okay for less than 5 years since effect of compounding is minimal

MFs are okay for more than 5 years effect of compounding combined with varied returns has historically beat inflation comfortably

The numbers look attractive for investing into other instruments that give 10-14% but with how much certainty it’ll always be above 10%? Considering the risk that comes with it, is FD not a better option? 🙂 Or is it worth taking that risk for more than 50 % chance of seeing those better returns?

8.25% qtly comp of 1 lac over 10 years gives you 2,26,281.

10% ann comp of 1 lac over 10 years gives you 2,59,374.

12% 3,10,584.

14% 3,70,722.

Thanks FFC for your reply.

I am aware 12.63% for an FD I mentioned is simple interest, but what am I missing here? How are the ones you mentioned with returns of 10-12% or 12-14% better options with their buil-in risks if any? Certainly they don’t look high enough numbers for me to consider them against FDs 🙂

Put the values in calculators, and find out how much money you will get, if you invest 5lakhs in each of the above mentioned instruments.

1. Put simple interest values for FD, and

2. Compounded returns of 10-12-14% for equity products.

And publish them here.

Over 10 years a good balanced fund (min 65% in stock) can give 10-12% and a diversified equity fund 12-14%

Thanks for your reply Ashal. What you suggested (investing the interest) certainly seems a better idea, but we have to be aware that we lose the benefit of compounding taking interest out monthly and so the interest applied is what ever is the headline yearly rate depending on the term – 8s or 9s. If the money works harder elsewhere taking money out every month feels a good option.

The actual rate is 8.25% (for a 10 year term) but with compounding in effect every quarter if we lock the money for 10 years – you are right: It amounts to the simple interest of 12.63% every year on the original amount.

It felt good to me to see such high number(12.63%), and I thought with no tax on my (NRI) interest earned and with no other risks it compares OK with returns we get by investing in other products, unless someone says to me that the returns in other products outweigh the returns using FD by some margin. Could you or someone indicate what sort of returns are possible using MFs/SIPs etc.. ?

Dear Venkat, there is a difference in actual yield & calculated yield. The ROI is not the same 12.63% as you are thinking. this 12.63% is the simple interest calculation over the period. A better option as per my understanding is to lock the interest in such FDs for 10Y & start receiving the interest on mly basis into your account & from there on the same interest should be invested in to Eq. MFs under SIPs.

thanks

Ashal