Why are mutual funds better Than Fixed deposits?

Price for certainty– In an ever uncertain world what is the price attached to something that is certain. Surely that thing which is certain should be available at a premium over others, and that thing which is uncertain should reflect a discount over something that is certain.

This extra return for investing in the uncertain over the certain should pertain to what is called the uncertainty premium.

Let’s take a fixed deposit. At the end of the term, when the FD matures you get the amount that was promised at the initiation. FD returns are certain- meaning you will get the amount promised at initiation Unless and until a bank default ( this being an extremely rare case especially with too big to fail banks).

Since the maturity amount is a guarantee, the interest rates related to an FD are really low. These range between 2.5-6% p.a with higher rates being tied to longer tenures (5-10 years).

In contrast, let’s look at something as simple as an index fund that tracks the nifty 50. These will tend to give returns in the range of 12-15% p.a on an average, with the catch being the uncertainty premium.

The returns on mutual funds or equity for that matter are not certain with the worst case being the permanent loss of capital. Hence investors in equity owing to the uncertainty related to the investments expect a greater return.

Now coming to the question of whether is the certainty associated with a fixed deposit worth the subpar returns that don’t even beat the inflation numbers worth it?

A simple answer would be no. The above is a graph showing if you had invested ₹ 10,00,000 in an index fund v/s a fixed deposit over a period of 5 years. Very simply put you are not going to get rich putting your money in fixed deposits of any sort. I wouldn’t even recommend it for the preservation of money. The only place where a fixed deposit would be useful is if you need money for a future event (marriage, education, etc) then putting it in a 1-year FD so that the obligation could be met would be a good choice.

Other than that if you want to get wealthy, there is no better way than to invest in equity, thereby bearing the uncertainty premium. With capital appreciation as well as dividends reinvested in an index fund the returns would far outweigh the benefits of an FD for long-term investment purposes.

Key takeaways:-

1)Use FD for short-term obligations only.
2)Invest in Equity for long-term wealth creation.
3)The uncertainty premium is the extra risk that is borne by investors for the additional returns.