Inflation is going to hit us in such a way that even though you're making money, in a real sense you will not be making a net positive return on your investments.
As an investor, we invest our money with an aim to earn a positive rate of return. However, the risk of earning a negative return exists in every investment. While negative return is possible in a market-linked investment such as a mutual fund or direct share, the fixed-income investments such as bank fixed deposits also carry a different kind of risk.
In a market-linked investment, there is a risk of losing a portion of capital when the value of underlying securities fall. In a fixed-income investment, the risk of losing capital may not be there (may exist in some), the risk of earning negative return may not be ruled out.
This risk arises out of the impact of inflation on the returns one generates across different investments. And, inflation is making a comeback in India. “Some countries like India and other countries have gone through lockdowns twice in the last 12 – 18 months. These have also led to production limitations and capacities. So, inflation is going to hit us in such a way that even though you’re making money, in a real sense you will not be making a net positive return on your investments,” says Santosh Joseph, Founder and Managing Partner, Germinate Investor Services LLP.
Such risk is primarily from the rising inflation which pulls the returns lower thus impacting the final return to an investor. So, if a bank FD offers a return of 6 per cent per annum and inflation is also 6 per cent, the net return is almost zero. At times, when FD rates are lower or the inflation is higher, the investment ends up earning a negative return. The capital invested is safe and secure but the effective inflation-adjusted return could be low or negative.
Negative return is more pronounced during periods of rising inflation with interest rates sliding down or lying low. Another key factor, other than inflation and interest rate, that impacts returns resulting in a negative return for the investor is the tax.
The interest income in bank FD is fully taxable in the hands of the investor as per the income slab. “If I were to take a ballpark figure, that FD rate would give me a 5 per cent return. Now let’s compute the real rate of return considering the TDS and inflation rate. After considering a TDS of 10 per cent, the effective return rate is 4.5 per cent. Now, let’s compare this against inflation, when you consider the inflation rate of 5 per cent, the real rate of return comes out to be negative 0.5 per cent with no real return. Therefore, it’s important for investors and other people to take a very informed decision that FDs today with rising inflation pose a threat of either low returns or negative returns,” informs Joseph.
The impact of tax on FD return is more for those in the highest tax slab compared to those who pay less tax rate. But, the role of inflation in impacting your returns cannot be ruled out, irrespective of the tax rates.
What you need to check is whether your investment is earning a negative return or if the return generated is at least a few percentage points more than inflation. Equity as an asset class has the potential to generate high inflation-adjusted returns and, therefore, is a better option for investors for meeting their long term goals. For retail investors, equity mutual funds are a good starting point to create wealth over the long term.
“Mutual fund investors have an edge over other investors. It is because, in the long run, things tend to even out. The greatest of crises tend to look small in hindsight as the economy continues to grow after the markets bounce back from the blow. MF investors know that mutual funds, on average, give you the GDP and inflation joint together as a return. Hence, they are protected for the long term, but for the short term, even mutual fund investors can face a lot of difficulties,” says Rachit Chawla, CEO & Founder, Finway FSC.
But, does that mean investing in bank FDs needs to be avoided? They actually suit those investors who are looking for capital preservation rather than to grow money. “My suggestion would be to take a balanced approach. If security is what you’re after, sure, you can invest in FDs. However, make sure you don’t invest more than 30 per cent to 40 per cent of your capital in the FDs as they’re not giving the best returns. Instead, park your remaining investment capital in other high-yield assets. For instance, gold can act as a valuable asset in times to come so that it can also be explored,” says Chawla.