Investing in bank deposits along with equity investments is optimal for goal-based investments. A query often received in this regard from readers is the concern that the post-tax return on bank deposits is low, as interest income is taxed at an individual’s marginal tax rate. Therefore, the argument goes that bank deposits are not attractive for working professionals. In this article, we discuss what makes bank deposits attractive despite their low post-tax returns.

Reinvestment risk

Suppose you want to buy a house 10 years hence. Based on current prices and adjusting for inflation, suppose you determine that your dream house will cost ₹5 crore. You decide to accumulate ₹1 crore towards 20 per cent down payment for the house, with the rest funded by a bank loan. Assuming you save ₹55,000 every month to achieve this goal, your required return will be 7.8 per cent on a post-tax compounded annual basis. You must decide your allocation between equity and bonds based on this required return.

Consider the bond allocation. Suppose you expect to earn 7 per cent per annum on your bond investments, translating into a post-tax return of 4.9 per cent (30 per cent tax). Because your required return of 7.8 per cent is on a compounded basis, your bond investments must earn 4.9 per cent compound return. So, the interest that you earn on your deposit must also earn 7 per cent return on a pre-tax basis (compound interest). But what if the bank credits the interest income into your savings account at the end of each year? You must reinvest the income at 7 per cent per annum each year for the remaining period of the life goal. This issue is that in any year, RBI could cut interest rates, thereby, making it difficult for you to reinvest your interest income at 7 per cent. That is the reinvestment risk. It is the most important risk you must manage relating to your bond investments. Investing in a recurring deposit and cumulative fixed deposit can help you manage this risk.

Conclusion

When you invest in a bank deposit, the maturity value of the deposit is known to you. So, ignoring the small possibility of the bank defaulting on your deposits, you know the amount of cash flow you will be able to generate at the end of the time horizon for your goal. That and the ability to manage reinvestment risk makes bank deposits relevant to your goal-based investments.

(The author offers training programmes for individuals to manage their personal investments)

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