Bank deposits are good for goal-based portfolios, especially for high-priority goals. Here, we discuss two benefits of investing in bank deposits and the cost associated with such investments.
When you invest to achieve a goal, you want to know how much the investment will accumulate at the end of the time horizon for a life goal. Equity can offer higher returns but carries a high level of uncertainty.
Bonds have a finite life. By bonds, we mean all interest-bearing investments, ranging from government bonds to bank fixed deposits. Because of a finite life, you know the maturity value of a bond investment. For instance, if you invest in a 10-year government bond, you know that the bond will be redeemed at par after 10 years.
But you must avoid reinvestment risk associated with such investments. Suppose you have lump-sum money which must earn 4% annual return over 10 years to accumulate the required amount to achieve a goal. This required return of 4%, called the minimum acceptable return (MAR), is a compounded post-tax annual return. This means the interest income you earn each year must be reinvested to earn 4% after taxes over the remaining time horizon for the goal. The risk that you may be forced to reinvest and earn a rate lower than 4% is the reinvestment risk.
Bank deposits can help you avoid such a risk. You must choose cumulative fixed deposits for investing lump-sum money and recurring deposits when you want to invest every month. Suppose you invest in a five-year cumulative deposit at 5.75%, the bank agrees to compound interest at 5.75% over the five-year period. This way, you can avoid reinvestment risk and know the maturity value of the investment at the end of five years.
The optimal choice would be to match the maturity of bank deposit with the time horizon for your life goal. There are two deterrents. One, bonds generate low return because they provide stable cash flows. You must, therefore, add equity investments to bond exposure to achieve life goals. And two, interest income on bonds is taxable at your marginal tax rate. Also, in the case of cumulative and recurring deposits, you must pay taxes on accrued interest (interest earned but not yet received). Despite these issues, bank deposits are important for goal-based portfolios.
(The writer offers training programmes for individuals to manage their personal investments)