Capital protection relates to the protection of your hard-earned money. Protection from the sense of depreciation and negative returns due to the impact of inflation on your savings. As an investor, you can protect your capital in various ways. And you can also inculcate this habit of protecting money to your children as well. Let us understand this with my childhood story.
Why must you plan for your capital protection?
In 2001 I was doing Engineering in Hospet of Karnataka. We had banking facility on our college campus. I opened my savings account in Gramina Bank. I was getting pocket money from my uncle. Almost INR 300-400 per week. It was INR 1200-1500 per month.
I can manage my monthly expenses with INR 500-600. Thus, I was able to save INR 600-800 per month. I thought of saving some money in bank account. But they told me that, money can earn only 3% per annum in the savings account. I asked if there any other options to earn better interest for my savings? They told me to open RD (Recurring Deposits) account which will earn about 8.5 percent per annum.
I started my first RD with INR 500 monthly contribution. I continued it for 3 years, which helped me to save money. Later I spent this money on completing my 8th-semester project.
The lesson from my childhood capital protection plan
The lessons I learned from this is, especially very useful for the students. The money kept in your savings bank account will earn only 4% (As per current bank interest rates). But is this good enough? No. As inflation is 6% (as per recent RBI data) our money is losing 2% every year.
What’re the other options available? Fixed deposits, Recurring Deposits which will earn 6.5 to 7%. But is still good enough? No. If the interest earned from FD/RD is more than INR 10,000 then it will attract tax. Then effective interest rate works about 5 or 5.5%.
Here also we are losing our money by 0.5 to 1%. FD and RD are good. They protect our capital, it’s a safe bet. But considering the tax implications, there are better options available.
Various options for capital protection for individual
What are the better options to protect and grow our hard-earned money? Let’s understand with an example.
Now I’m 36 years old, I’m earning a regular monthly payment for my work. After 50-55 years I’m retired. I have built a corpus of 75 to 80 lakhs in the form of savings it may be my provident fund, gratuity, LIC policies and so on. Now I need to manage this money for rest of my life.
There are 4 objectives –
- capital protection
- Regular Income,
- Higher liquidity
- Lower tax implications on the interest
To fulfill these objectives, I have many options. Either I can keep this money in Bank FD which will earn me 7% per annum. But the challenge with FD is that interest will keep falling over the period of 5-6 years.
In the year 2000 FD rates were more than 10%. Later in 2010 interest rates were reduced to 8%. Now in 2018 interest rates are down to less than 7%.
I will not be able to fulfill my first objective of capital protection. Because my money is losing its value every year. Same is the case with postal savings schemes.
Investing in bonds, safe capital protection with capital appreciation
Then what to do, I need to look for alternate options. You might have heard about Govt Bonds, PSU Bonds, Corporate Bonds, Corporate FD’s, Non-convertible Debentures (NCD’s).
These are safer instruments just like FD’s. Here also interest rate fluctuates but only for the interest (Profit) rates, our principal amount will be safe. If we invest through mutual funds, these are called DEBT Funds.
The one or more combination of bonds, corporate FD’s and NCD’s form together is called DEBT Funds. These funds will be managed by the professional and expert fund manager. This much better way of investing in bonds.
These debt funds are better than FD’s. They earn 1.5 to 2% better interest rate than FD. They are also highly liquid. Which means we can withdraw the money in a 2/3 day in case of emergency.
Why prefer debt funds over banks fixed deposits?
Let us understand how it works. Let’s assume FD is giving 6% and Debt Funds are giving 8% per annum. I invested 10 Lakh for 5 years,
The interest in FD is INR 60,000 and Debt fund is INR 80,000 respectively. After 5 years the net accumulated interest in FD is 3 lakh and Debt fund is 4 Lakh.
Not only the 1 lakh extra profit, but let’s understand how tax implications work.
|Year||FD @6%||Debt Fund @8%|
|Tax on the interest||30000||20000|
|For 10% tax slab|
If you see the above table clearly, the money saved in FD would have earned INR 2,70,000 in 5 years. This is after deducting 10% TDS (Tax Deducted at Source). TDS amount is INR 30,000. But same money invested in Debt funds would have earned me INR 4,00,000. The extra earned money is INR 3,80,000.
This is where the Indexation benefit comes into the picture. Ideally, if investor stays invested for more than 3 years, the investor is eligible for indexation benefit for the interest he earned for his principal.
In Indexation, inflation percentage is reduced from the net tax rate.
For example, the investor is in 10% tax bracket and assuming inflation is at 6%, then 10 – 6= 4% which we have considered in the above example. The difference value between saving in banks fixed deposits and investing in debt funds is INR 1,10,000.
The objectives such as capital protection, high liquidity, better tax rate and regular income generation are met through Debt Funds.
FD’s, a money market instrument, are good, like landline telephones. Which were good and safe. But with the landline, we can only talk. Debt funds are better, like smartphones. We can talk, watch a video, listen to music and use the internet.
Thank you for reading, hope you enjoyed and learned few important points. For any suggestions, questions please mark an email to ‘email@example.com’. For more such information you can register here. You can also subscribe to my web page. Thank you all.
Vikram Sapparad (Wealth Coach and founder of Arthika Swatanthra)