Fixed deposits: Great short-term investment option but...

Recently I was at my old school alumni get together. We soon finished the standard 'Do you remember the time when...'and the 'Did you know that the character played by Aamir Khan in Taare Zamin Par is named after our school art teacher? etc.

We then got around to discussing what each of us was doing with our lives since the time we had last met. I was meeting Sumeet almost after a decade. In our circles he was known as Mr Risk-Taker as far as his investment style was concerned. Knowing my background very well, Sumeet turned to me for advice.

Sumeet had always been a firm believer that equities as an investment class will always outperform other asset classes in the long run, and accordingly invested monies very systematically into equity oriented mutual funds as well as a couple of specific stocks that he was a firm believer in.

Consequently his investments did very well. Now his son was set to join an Ivy League college next year, for which fees was to be paid in six months time. Consequently over the last three months or so, he had started selling off his investments as the date of fee payment was coming closer. He was selling a pre-fixed amount every month and moving this money into safer instruments, as he did not want to keep this money in equities as the goal was nearing.

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I marvelled if all investors were as well planned as he was, they would not need any financial planning (and planners like us to assist them). Anyway I asked him what safe avenue had he chosen to park the liquidated investments.

He proudly said that he has been investing into fixed deposits (FDs) that were giving him 9 per cent per annum. I was quite surprised as his requirement was just six months away and none of the FDs in the markets for such a small duration would offer him such attractive returns.

When I started questioning him further, he said that every month he was buying FDs with a tenure of one year and a few days as the yield (returns after deducting applicable tax) on the same were on a higher side and also offered him liquidity as he could break the FD anytime and take out his money without any premature withdrawal penalty.

I was surprised to note that Sumeet had no idea of how FDs work and his bank relationship manager was blindly asking him to invest money in to one-year-plus FDs without even asking him, when was he planning to withdraw. I also asked my friend if he had any clue about the implications if he withdrew the money at the end of 6 months instead of the one-year-plus that he had contracted when making the fixed deposit.

He was clearly under the impression that he would get 9 per cent per annum. Even if he withdrew the fixed deposit in just 6 months time, as there was no premature withdrawal penalty.

Here was my chance to correct him and not only him but all those who are planning premature withdrawal. I asked if he knew what interest rate the same bank was offering for a six-month deposit.

He did not, but I did. It was 7.25 per cent. What no pre-maturity penalty meant was that he would get this 7.25 per cent rate per annum on his deposit without any deduction. If there had been a pre-mature withdrawal penalty, of say, one per cent then on his early withdrawal he would have got an interest rate of 6.25 per cent which is 7.25 per cent per annum less one per cent. This was a revelation to him.

He then asked me what other options were available for such short-term investments. Well, fixed deposits (with good banks) are a great option (safe and with guaranteed returns) for short durations, I told him. But given his high tax-paying status, dividend-paying arbitrage funds were also a good option.

Other options were shorter duration FMPs as well as ultra short-term funds which could give (not guaranteed though) slightly better returns than a fixed deposits and more importantly the returns could also be structured in a more tax-friendly manner.

The alumni meet ended with the usual exhortations of meeting again soon. Whether we would meet again in the next six months or so was not so sure. But I was reasonably sure I would get a telephone call from Sumeet soon.

Looking forward to hearing from you buddy! But this time there will be a bill following the advice.