Fixed Deposits Beats Stocks? Financial writers need financial literacy first  

April 12, 2012

Recently both Times of India and Economic Times had claimed that fixed deposits trumped Sensex returns over the last 20 years. There are at least five flaws in the argument making the data, while correct, completely irrelevant in practical terms

Debashis Basu and Aditya Govindaraj

On 9 April 2012 Times of India (TOI) and Economic Times (ET) (Don't buy and forget if you invest in stocks for the long term) carried an article which claimed that “it is high time investors shed the notion that they can earn handsome returns if they invest in stocks and forget about them for a very long time”. In other words, it was a case against the ‘buy and hold’ principle, which has served many a long-term investors well. The proposed solution: either do market-timing or invest in bank FDs (fixed deposits). This startling claim, which are backed by solid facts, is being discussed everywhere. Financial advisors and mutual funds are scrambling to justify why should one buy and hold stocks for the long-term if it does not even beat safe returns from bank FDs—far from fetching 3-4% more which is what one would expect after having taken the risk of investing in equities.

It is a well-known fact that equities trump bonds or fixed deposits over long periods of time in most countries. However, when we stumbled upon the article which claimed the opposite, we got curious, especially since Moneylife believes in the wealth-creating power of stocks over the long term. We looked closely at the analysis to check whether we missed out on anything.

According to the article, if one had invested in Sensex, in 1992 when it was 4,285, one would have got returns of 7.26% over the last 20 years, till March 2012. On the other hand, it said that if one had invested in one-year fixed deposits, over the same time frame, the returns would have yielded a much higher 8.35% returns. “This means that if you had invested Rs10,000 in the Sensex in 1992, it would have grown to Rs40,308 now. Several debt instruments would have yielded higher returns during this period. If the same money had been invested in a one-year fixed deposit with a commercial bank and rolled over every year, it would have grown to Rs49,722. Since this was for the long term, investors could have opted for five-year FDs that offered higher rates. This corpus would have been bigger at Rs70,854.” Based on selective facts, the argument is flawed for at least five reasons.

1. Arbitrary Dates: Any point-to-point comparison is completely arbitrary. This study coincidentally chose 1992 as the starting date. If one had entered the market a year earlier or a year later, the returns would have trumped fixed deposits. For instance, if you had entered the Indian market in 1993 instead of 1992, when Sensex was 2,280, you would have got 11.29% returns. Even a year earlier, in 1991, would have yielded a much higher returns of 13.73%. This is a huge difference from the 7.26% return noted earlier. Additionally, both are higher than either one-year or five-year fixed deposit schemes. Therefore, it is not only a matter of timing, which is fairly obvious, but also a question of conveniently choosing the time period when fixed deposits trump equities. It is very easy to look at the rear-view mirror and make pronouncements. This also applies to mutual fund performance which is why we choose rolling returns, as the basis of our analysis.

2. Tax: The biggest flaw is that there is no mention of tax. These returns are pre-tax. When the government takes away 30% of your interest income above a certain level as tax and allows you to earn long-term capital gains tax-free, it is foolish to consider pre-tax returns for comparison. Take into account taxes, and Sensex easily trumped post-tax FD returns. Instead of the 8.35% (one-year FD) returns mentioned earlier in the article, the return was found to be 5.86%, over the 20-year period. Similarly, the five-year FD scheme returned slightly higher at 6.21%. This is well below the 7.26% in case of equities even starting at 1992. We have assumed uniform taxation of 35% because while it is 35% now it was above 40% in the early 1990s.

3. Dividends: Like taxes, the ET/TOI article ignores another element—dividends. Over the long period of time, small dividends can make a huge difference. In our case, we found out that by just reinvesting dividends, every year, the annualised returns turned out to be 8.29%, a good 1.53 percentage points higher. This is a huge difference considering the power of compounding over long periods of time and erodes the edge of FDs fully.

4. Lumpsum Vs SIP: The study assumes that all the investment was made on one particular day in 1992. Most readers of Times and ET earn regularly, save regularly and should invest regularly. They don’t make lumpsum investment or should not. Any financial literate person knows the importance of regular investing, or Systematic Investment Plan (SIP), which can work better than lumpsum investment usually. Our study showed that if one had invested just Rs500 (or any amount for that matter), every month, for the period 1992-2012, this strategy would have netted you a cool 11.60% return, again higher than FD returns.

5. Index Buying: Finally, who bought Sensex in 1992 or buys even now? You could invest in units of Unit Trust of India in 1992 and most people would have advised an average investor to invest in blue chips like ITC and Hindustan Lever (now Hindustan Unilever). These stocks have done far better than Sensex. Mutual funds were not in the vogue then. Index investing wasn’t even present in India then. There are very few people who invest in index funds even now. The best performing mutual funds have done 5-6% better than Sensex (and bank FDs on average).

If you are interested in personal finance and financial literacy, you would have to do your own homework and not trust the findings of either distributors, financial companies or media, packaged in dramatic headlines, because financial journalists themselves can be lacking in financial literacy.