A Risk bigger than inflation risk

Today I’m going to talk about a risk to your financial planning which is bigger than the inflation risk. This risk is the risk of falling interest rates. 15 years back the rate of interest on Bank fixed deposits was in the range of 12 to 18% if you had a a fixed deposit for 1 to 5 years. Today the same interest rate on similar Fixed deposit is in the range of 6 to 8% only.

In many Western economics the interest rate is between 0 to 2% only.  it will not be far fetched to think that India would be heading towards same direction.  Government would be more inclined to reduce interest rate in order to boost the economy. This should be a wake up call for all those who plan to  have only fixed income securities in their portfolio. I would suggest that you have a look at the following chart which shows the trend of interest rate in India for last 20 years.

inflation risk

Risk is usually understood as an exposure to “danger or hazard”. In investments, risk is defined as the possibility that what is actually earned as a return could be different from what is expected to be earned.  For example, if an investor buys a real estate with the expectation that the property would appreciate by 30 to 40% but instead the property appreciates by only 10%. This difference between actual versus expected returns is the risk in his investments.

A good financial planner / advisor should address this risk and take into consideration the interest rate which is prevailing currently and also the interest rate which is most likely to prevail in future while designing / building client’s financial plan and portfolio.

Earlier I spoke about the risk of falling interest rates. I also spoke about the scenario wherein 15 years back the rate of interest on Bank fixed deposits was in the range of 12 to 18% if you had a a fixed deposit for 1 to 5 years. Today the same interest rate on similar Fixed deposit is in the range of 6 to 8% only.

A good  financial advisor will advise on various strategies to address such type of risks such as staggering and diversification for example a person who is relying on fixed income could lock in their interest rate with the longer tenure for duration of FD. But this brings a unique problem that is — if in case you need part of the fixed deposit for urgent need then you have to break entire fixed deposit which in turn means a loss to you as banks levy penalty on pre-closure of Fixed deposits. You can address this problem by laddering fixed deposit. See this info-graphic to understand how laddering fixed deposit will enhance your returns.

inflation risk

 

Here’s a small video which will explain you Laddering in more detail (Please note that I am not associated with this video in anyways and has been put here just for your understanding):

 

Another strategy is Diversification among different fixed income deposits, i.e. One could diversify their Fixed income portfolio between different type of fixed deposits such as Bank fixed deposits, Corporate fixed deposits, Tax free bonds and Long term Sovereign Government Funds. While this strategy does not address the risk of falling interest rates completely, it does mitigate the impact of it on your portfolio.

 

Disclaimer: I am not your financial planner / advisor. Also, I am not SEBI Registered Investment Adviser. I write articles to share my opinion and experiences of managing money. The information and services may contain errors, problems or other limitations so I request you to contact your Financial advisor, CA or legal advisor for professional advice before making any financial decision. All views and opinions shared here are purely individual opinions. If you have any questions or concerns regarding this post then please contact me and let me know. Also please read the full disclaimer here.

Posted in Financial Planning and tagged CA, financial Advisor, financial Planner.