Fixed Deposits – Ultra-Conservative or Financially Prudent?
There is a difference between savings and investment. Investment vehicles are higher-return capital appreciation while savings are more stable funds with lower returns. Fixed deposits would fall into the category of savings. The ultimate goal of savings is to provide for times of necessity or finance some future want. The goal of investment is to accumulate wealth. Fixed deposits provide security and stability for your funds. As a fixed-rate financial vehicle, it faces two risks; liquidity risk and purchasing power risk. These risks must be assessed in terms of your own financial planning to determine whether fixed deposits or similar plans can work for you.
Any fixed-rate investment would face purchasing power risk. This pertains to the real value of money over time. The interest rate on a fixed deposit is invariable or declared. Headline inflation fluctuates. If headline inflation over a period is higher than the interest rate on a plan, the fund would have a negative real rate of return. This suggests that it would actually have a lower purchasing power relative to when it was initially invested. To avoid this, a fixed deposit should be selected if it is likely to maintain an interested rate that can almost match or surpass headline inflation. The interest rate on a viable fixed deposit should never be below that of core inflation. Core inflation is based on headline inflation minus the impact of food price.
Liquidity risk is also a major concern when investing in fixed deposits. Most fixed deposits have surrender charges or penalties. Your funds would not be available without penalties until the fixed deposit matures. There are even fixed deposits with penalties on capital. These should be avoided generally unless they provide significantly higher interest rates than other available savings vehicles. Plans that do not promise loss of capital on surrender are ideal. Such plans reduce the risk involved in investing in a fixed deposit or a similar type of plan. Before placing a lump sum in a savings plan for a fixed period, one needs to ensure that one has enough liquidity. This means that you should have an adequate emergency fund and protection products. Protection products preclude the need to surrender fixed-period plans by providing income that is not earned when necessary.
The ideal fixed-rate savings plan preserves the real value of your funds, provides security and has minimal surrender charges. If you have a low risk-tolerance, then a fixed deposit plan may work for you. All you have to do is ensure that the interest rates can match headline inflation and that there are full guarantees on your investment. Failing this, it may be better to take more risk with your money in order to preserve its real value. Once they meet the criteria outlined here, fixed deposits can prove useful for investing retirement funds as well. Choosing the right type of savings plan can save you thousands of dollars more in the long run. Using a good fixed deposit alongside other capital appreciation vehicles is a manifestation of financial prudence, not conservatism.
Darrell Victor is a financial services sales professional who specialises in retirement planning and group benefits.
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