Yield or return on investment is measured in two ways:
- Inflation adjusted rate of return
- Inflation unadjusted rate of return.
Real rate of return for an individual is inflation adjusted rate of return because of the fact that an individual investor saves and invests to meet his future needs, e.g., purchase or construct a house of his own, child education, retirement planning, or to meet unforeseeable exigencies.
All the future goals are met at then prevailing prices which are largely influenced by the rate of inflation over the period. Inflation in monetary prices erode purchasing power of money. Due to inflation prices of commodities and services tend to rise over the period.
If the rate offered on investment is lesser than rate of inflation the compounded value of investment fall short of requirements. One more point here needs investors attention and the point is applicable rate of income tax. Tax takes away a substantial portion of earning of the individual falling within tax bracket. As rate of income tax increases in slabs, the investor must work out his post tax rate of return first and then he should compare it with average rate of inflation.
Let us illustrate it.
Suppose you put INR 10000 in a bank fixed deposit for five years @ 7.5% (since rates are falling so rate of interest Indian commercial banks are offering on FD are hovering around 7-8% at present) and you fall in 30% tax bracket.
Since interest earned on bank FD is taxable, tax payable on annual tax earning is
10000 × 7.5% × 30% = 225 + 3% Edu. Cess = 231.75This will leave INR 750-231.75=518.25 (5.1825%) as post tax return from the FD for you.
Compounded sum at this post tax rate for 5 years will become INR 12876. Now discount this money with the average rate of inflation estimated for the same period. It is estimated that the same will be in between 5.5% and 6% if the current trend continues in the near future. Optimistically if taken 5.5% discounted value of Compounded sum comes INR 9704.
It means at the time you book a bank FD at the given rate you book a loss of INR 296 for 5 years instead of an income, provided you are in 30% tax bracket. Those who fall in a lower tax bracket may expect a nominal gain at the given rate of inflation (5.5%). If the rate of inflation stay at a higher order this will upset the calculations.
Note that investment in 5 year FD can be shown in 80C for exemption, so that factor is also there. But the above calculation just gives the general idea how you loose money in bank deposits after adjusting it for inflation.
Apart from the risk of upward movement of the rate of inflation there is yet another reason as to why a higher rate of return is required. The reason lies in the method of estimating rate of inflation.
In India inflation data are calculated on two different basis:
- On the basis of wholesale commodity price
- On the basis of consumer prices
The second is valid for household individuals. But the problem is that the Consumer Price Index (CPI) are computed taking the prices of daily consumption items in a given proportion. Thus the CPI reflects inflation (price rise in daily consumption items), not in the items average individual save for.
Normally we save to buy house, to pay for children education expenses, to meet children expenses and to meet medical expenses in case of ill health. The past experience show the rate of rise in these items cost have been much higher, about 10% to 12% per annum. When pre tax rate of return is barely 7.5% how can it help you meet your target?
Then, what should be right strategy? Answer is- put a small proportion of your savings in bank just enough to provide handy cash to meet emergency cash needs. To meet long term goals go for PPF (EEE deposit scheme) and National Pension System(NPS) (EET deposit scheme) for higher yield investments.
If you can invest more money look at proven mutual fund plans, preferably multicap funds and balanced (hybrid) funds in order to keep level of risk at lower side.
That's all for this topic Bank FDs - A Loss Making Investment. If you have any doubt or any suggestions to make please drop a comment. Thanks!
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