It is very common for the typical employed person (or) Self employed professional to park most of their household savings in Bank Fixed Deposits (FD). But do FD's earn a worthwhile return for you?. Let's see..
For one to appreciate returns on your FD investments, it is essential to understand a term called "After Tax Real rate of return".
The After Tax real rate of return is calculated as Nominal Rate of Return from FDs (%) - Tax Deduction at Source (TDS) - Prevailing Inflation Rate (%).
Let us look at this example,
Fixed Deposit Interest Rate - 7.0% (View page)
Inflation Rate - 4.2% (View RBI Website)
Tax Rate for FD Interest - 10% (applicable if yearly interest accrued is Rs. 10,000 or above)
Hence, the After Tax Real rate of return is calculated as:
Interest earned = 7.0%
Tax Deducted is 10% on 7.0% = 0.7 %
After Tax Real Rate of Return = 7.0 - 0.7% = 6.3%
Prevailing Inflation Rate = 4.2%
After Tax Real Rate of Return % = 6.3 - 4.2 = 2.1% (from FDs)
In contrast, let's look at someone investing in equities.
For illustration, let us take the example of a leading company like Hindustan Lever, a leading Consumer Goods company operating in the Indian market, whose products are widely used by a large segment of population.
The yearly (annual) returns delivered by Hindustan Unilever is 17.2% (View source)
(Its share price moved from INR 361 in Nov 2011 to INR 802 in 2016, with multiple dividends thru the years.
Applying the simple compound interest formula, the yearly rate of return works out to 17.2%.
Hence, real rate of return = 17.2 - 4.2 = 13.0% (From Equity investment)
As a bonus, returns realized from equity investments DO NOT GET taxed (0% tax if investment is held for one year or more), so the After tax real rate of return is same as above i.e., 13.0%
Interestingly, buying the shares of a well selected portfolio of companies helps you to "ride the inflation" as the prices of the products of most companies keep increasing to adjust for inflation. So, instead of being affected by inflation (or) your returns getting needlessly eroded, you can "make inflation your friend" by investing in equities of well selected portfolio of companies.
Whether you wish to invest your hard earned money in Fixed Deposits that generate just 2.1% returns (or) equities of well selected portfolio of companies that can generate significantly superior returns is finally a call for you to take.
If you need expert help, welcome to get in touch with us
Sethu V, Founder of Dhanayoga. I'm a Serial Entrepreneur, Management Consultant, Value Investor and Certified Investment Adviser. Connect me at http://linkedin.com/in/venkatsethu