It is a common perception that bank deposits are risk free investments and therefore are very safe investment avenue. But are bank deposits really risk free? Answer to this question will depend on your perception of risk.
If your risk perception restricts to only preservation of principal invested then bank deposits can be considered as risk free. Although here also it is not 100% safe because if one or more banks collapses you may end up getting only up to Rs.1 lakh back (due to deposit insurance) from each collapsed bank.
But preservation of principal is not sufficient to define risk. This is one fundamental risk. There are other risks which need to be understood with reference to any investment. For bank deposits following risks are also relevant:
- Inflation Risk
- Reinvestment Risk
- Liquidity Risk
Inflation risk is risk of loosing purchasing power on maturity of deposit. Can your bank deposit protect purchasing power of your saving? Let us assume that you invest Rs. 1,00,000 in a ‘safe’ bank for 5 year deposit at 9.25% per annum interest compounded quarterly. After 5 years the maturity amount will be Rs. 1,57,970. If your income tax bracket is 30% then you will get net amount of Rs. 1,40,057 after paying income tax & cesses. It translates to after tax return of Rs. 6.97%. If price inflation during these 5 years averages to 9% per annum then your maturity amount would have lost purchasing power at the end of 5 years. In purchasing power term Rs. 1,53,862 now is equivalent to Rs. 1 lac five years back. You lost Rs. 13,805 worth or 13.81% purchase power by investing in the bank deposit. This may seriously affect your financial goal achievement unless you have considered it while investing.
Reinvestment Risk
Reinvestment risk means possibility of getting lower rate on renewal of deposits if your investment horizon is larger than deposit term. Let us assume that you are saving for some long term goal like retirement where investment horizon is 20 years or more. Most banks will only accept deposits for a period of 7 or maximum 10 years. You need to invest the matured amount again to match your investment horizon. There is a possibility that after 5 or 7 years the rate of interest may be lower than your current rate. So you are also facing reinvestment risk for your long term savings.
Liquidity Risk
Liquidity risk is the risk of getting lower than appreciated amount if you need the money before the maturity date. Bank deposits carry this risk since on premature withdrawals penalty charge is applicable.
In summary bank deposits are not really as risk free as common perception tells us. They carry inflation risk, reinvestment risk and liquidity risk. Amongst these inflation risk is most serious and has heaviest implication. When selecting bank deposits be aware of these risks and plan your investments accordingly. If you are not sure seek advice from your financial planner.
