Fixed Deposits are often considered the safest instruments for investment. Under a Fixed deposit, you invest a lump sum amount with a predetermined interest rate for a certain time. However, inflation can play a major role in the interest earned through fixed deposits. In this article, we will focus on how inflation can impact the returns of FDs.
What is an Inflation?
- Let’s suppose in December 2023, you used to buy a product at Rs 50/kg.
- After one year, in December 2024, you buy the same product but this time the cost is Rs 60/kg.
- The difference in the price of the same product (Rs 60/kg- Rs 50/kg) i.e. Rs 10 is the inflation.
Inflation refers to an increase in the price of goods and services over a certain period of time in an economy (Eg. India). It depends on the increase or decrease in demand or supply of goods and services.
How does inflation affect Fixed Deposits Return?
- Suppose you have invested in a fixed deposit which provides you a return of 6% per annum.
- The inflation in that year accounts for 4%.
- The difference between your fixed deposit interest rates and inflation rates decides whether the value of your investment is positive or negative.
- In this case,
Real return: (Nominal interest rate- inflation rate)
Real return: 6%-4%, i.e. 2%.
- This means that your investment has increased your purchase power by 2%.
Fixed Deposit vs Inflation:
The has been a lot of speculation about the interest rate provided by FD and inflation rate per year. The current inflation rate stands at 3.65% and the average interest rate provided by fixed deposits ranges between 4% to 7.75%.
This states that, currently, in India, the fixed deposit returns are positive, increasing the purchasing power of an individual.
- Decreasing purchase power: If inflation stands at 7% and your FDs return stands at 6%, then the purchasing power of those investments is decreasing.
- Increasing purchase power: If inflation stands at 4% and your FDs return stands at 6%, then the purchasing power of those investments is increasing.
Note: Purchase power refers to the power that a certain amount of money holds to buy a certain goods or services.
Eg. Suppose you pay Rs 60 for 1 kg of rice, after a year the same rice costs you Rs 65, in this case, the purchasing power of Rs 60 has been decreased, you need more money to buy the same quantity of product.
Strategies to reduce Inflation Impact:
If your investment returns are negative due to the impact of inflation, you can follow these steps to get over it:
- Diversify your portfolio: It is always advised to diversify your portfolio across different asset classes. Your investment basket should contain equity, debentures, bonds, and other instruments to balance the returns. Do not park all of your money in a single instrument.
- Invest in high returns investments: While diversifying your portfolio, you should always choose some investments that come with high returns. Even if you are investing in fixed deposits, always choose fixed deposits with higher interest rate.
- Laddering: Consider investing in multiple fixed deposits with different interest rates and maturity periods. This manages and balances the returns and liquidity. Even if your one FD returns are negative, others can balance that and the end return can be positive.
Winding Up:
We all invest so that our money can grow but it is also important to keep an eye on other factors too. Inflation can’t be controlled but your investments and returns can be controlled. So, always check out all the factors before investing in any instruments. Even though it is getting tough for you to understand, do consider a financial advisor. Just for our investors’ interest and their safety, we bring you the Divadhvik- Your friend in investing. Divadhvik will guide you on your journey of investing. Their 10+ years of experience will help you in achieving your financial goals.
Frequently Asked Questions:
- What is a Fixed Deposit?
A fixed deposit is an instrument where you can invest a lump sum amount for a predetermined period on which you will get a fixed rate of interest until its maturity.
- How can we measure that our returns are greater than the inflation rate?
To find out whether your returns are positive or negative, you can follow these steps:
- Determine your Investment return.
- Determine the inflation rate of the economy.
- Now use the formulae: Real return: (Nominal interest rate- inflation rate)
- What are other ways to diversify your portfolio?
You can diversify your portfolio by investing in equities, debentures, real estate, bonds, and other securities. Always take the help of a financial advisor before investing.
