As investors, many of us seek comfort in the tried-and-true method of fixed deposits. It’s a safe, secure ground where we can leave our savings, hoping for a return on our investment. However, have you ever considered the risks that lie beneath this placid exterior?
Yes, you read that right – fixed deposits and risks in the same phrase. Given the widespread belief that fixed deposits are the most secure investment option, this may appear paradoxical. Of course, some risks are involved, as with anything in life.
This article will reveal the risk of investing in fixed deposits, an area that is unfortunately less familiar to the average reader.
Understanding fixed deposits
An investment in which an individual places a lump sum with a bank or non-banking financial company (NBFC) for a specified period of time is a fixed deposit (FD). Interest is accrued on the deposited amount in the FD at a predetermined rate set when the account is established. A deposit’s interest rate is based on the amount of time the money is kept in the bank.
Also read: What is a systematic deposit plan?
Why fixed deposits are considered safe
Is fixed deposit a good investment? Yes, fixed deposits are regarded as a secure form of investment for the reasons outlined below:
Guaranteed returns: FDs provide assured returns and entail no potential loss of the principal amount. Market fluctuations do not impact FD returns.
Stability and security: FDs exhibit a lower degree of volatility in comparison to alternative investment choices such as real estate, stocks, and so forth. Due to its reduced instability, an investor can anticipate an assured return on their investment.
Risk-free: As a risk-free alternative, it is favoured by most investors nearing or having already entered retirement.
Although fixed deposits may appear to be a secure and well-liked investment choice, it is imperative to recognise that they carry some risk.
Let’s explore all the different risks of fixed deposit investment. Gaining this knowledge will enable you to make well-informed decisions and, perhaps, protect your assets from accidents.
Liquidity risk
The possibility that an investor may encounter problems when attempting to withdraw or sell their investment prior to its maturity is known as liquidity risk. Liquidity risk occurs when funds need to be accessed prior to the term’s end.
The money you put into a fixed deposit will not be accessible until the end of the term you choose. It signifies that you’re committing to keeping the funds in the account for a specific amount, which could be anything from a few months to a few years. You might be subject to penalties or a lower interest rate if you withdraw your money before the term ends.
Some investors construct a ladder of fixed deposits, with various fixed deposits maturing at different times, to reduce their exposure to liquidity risk. This method lessens the need to prematurely withdraw funds from a fixed deposit while providing a steady income stream.
Default risk
You risk losing your fixed deposit money if the bank or other financial organisation where it is held fails to meet its obligations. It is called default risk.
Although bank failures are highly unusual, they do occur. Up to Rs 5 lakh per person per bank is guaranteed by the Deposit Insurance and Credit Guarantee Corporation (DICGC) in the case of a bank default. This amount includes interest. Default risk is present for any amount exceeding that.
Diversifying your investments across various banks can help reduce the risk of default. This way, your exposure to the risk of default is contained to the amount you have in that specific bank, even if that bank defaults. You should only put your money into fixed deposits with NBFCs or banks that you know and trust to be financially sound.
Inflation risk
The possibility that inflation will outpace an investment’s rate of return is known as inflation risk. What this means for fixed-income investments is that interest payments might fall behind the rate at which prices are going up for consumers’ goods and services.
Due to inflation, money gradually loses its buying power. Despite the certainty of a fixed deposit’s return, it may not be able to keep pace with inflation. It is possible that the interest you earn won’t be enough to cover your expenses in the long run.
Investing in equities and other assets with long-term inflation-beating potential can help investors reduce their exposure to inflation risk. Such investments are not without their own risks, so an investor’s risk tolerance and long-term financial objectives should guide their selection.
Interest rate risk
An economic risk that might materialise due to interest rate swings is known as interest rate risk. When discussing fixed deposits, this risk refers to the potential for your funds to remain stagnant for an extended period of time with a low rate of return.
An investor in a fixed deposit locks in an interest rate when they put money into the account. However, monetary policy, inflation, and general economic conditions are just a few variables that can cause interest rates to change. You will lose out on a potential increase in your return if interest rates increase after you have made your fixed deposit.
One way to reduce exposure to interest rate risk is to choose fixed deposit maturities that are shorter. It is because you can reinvest the funds at potentially higher rates in the event that interest rates rise. Another option to hedge against interest rate risk is to open a floating-rate fixed deposit with a bank. The interest rate in this kind of account is tied to a benchmark rate.
Also read: Interest rate risk – Meaning and risk management strategies.
Reinvestment risk
If an investor can’t reinvest their investment’s cash flows (like interest payments) at a rate equal to or higher than their current rate of return, they’re taking on reinvestment risk.
Reinvestment of the principal is an option available to you when the term of your fixed deposit ends. The rates you locked in may have been higher, but the ones that are currently in effect when you reinvest might be lower. Returns on your reinvested capital may be reduced as a consequence of this.
Holding non-callable securities can help investors lower their reinvestment risk. With cash being available less frequently and not requiring frequent reinvests, investing in longer-term securities becomes an option as well.
Other strategies for reducing exposure to reinvestment risk include bond ladders, a collection of fixed-income securities with different maturities. There may be a balance between bonds maturing at low-interest rates and those maturing at high rates.
Taxation risk
You risk having your pre-tax returns from fixed deposits affected by tax laws or regulations changes.
Interest on savings accounts is typically subject to taxation at the individual rate. Your total income, including interest earned on a fixed deposit, will be taxed at your marginal rate.
Consider tax-saving fixed deposits to lessen the impact of tax risk. You can deduct up to Rs. 1.5 lakh—the maximum amount you can invest in these fixed deposits—from your taxable income under Section 80C of the Income Tax Act. The deposits have a 5-year lock-in period.
Financial plan fitment risk
The risk that an investment won’t match with your long-term goals and risk tolerance level with risk is known as financial plan fitment risk.
A person’s risk tolerance and financial objectives are two things that are unique to them. Your investment decisions should be guided by these factors. However, these considerations may not necessarily apply to fixed deposits.
For instance, fixed deposits’ modest returns may not be enough if building wealth over the long term is your financial objective. The same holds true for those who are ready to take on greater risk in the hopes of potentially higher returns; fixed deposits may not be the best choice for them.
One way to lessen the chances of financial plan fitment risk is to have a clear idea of your financial goals and your risk tolerance. Invest in a variety of asset classes that complement one another and your long-term financial goals. Keep your investment portfolio in line with your evolving financial objectives by reviewing and adjusting it on a regular basis.
Also read: Risk tolerance and investment strategy
Bottomline
Understanding the risks is just as important as knowing the rewards when it comes to investing. Although fixed deposits are often seen as a safe haven, they do come with certain risks. To better coordinate your fixed deposit investments with your financial objectives, it is important to be knowledgeable of these risks.
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