Why Bank Fixed Deposits Alone Won’t Make You Rich

At a minimum, your investment needs to counter the corrosive effect of inflation on your savings. And for an emerging economy like India, inflation will be sizable. Consider CPI inflation in India over the last two decades.

Returns of different asset class(es) 

Consider the chart below comparing  returns from investing in the NIFTY, SENSEX or Fixed Deposits from 1994 until now.

Rs 100 invested in FDs in 1994 would be worth Rs 450 by the end of 2013 except taxes would take a chunk out every year leaving you with just under Rs 300 (3x your initial amount).
In comparison, investing in the NIFTY or SENSEX would leave with you 4.5x and 5.5x respectively, with gains on stocks held for longer than 1 year do not attract tax. Note that this return does not take into account the 1.5%-2% annual returns in dividends.
A comparison of different asset classes:

Returns of Equities Gold Property Fixed Deposits in India

There is no doubt that bank fixed deposits (FDs) are considered safe in that you will most likely get your money back. But did you know that bank FDs can negatively affect your savings over the long term?

#1: FDs give returns below inflation

The average inflation rate in India for the last 2 years (2012-2014) is 9.76%. Most FDs only give you about 8.5% interest before tax and around 7% after tax. This means, you are effectively losing money every year you invest your money in a FD.

#2: FDs are taxable, which further reduces the net amount you earn

Compared with equity mutual funds, long term returns from which are tax free, FD interest is taxable at your current tax slab. The higher your income, the lower your FD return will be.

That raises a question- "if bank fixed deposits are not a good way of allocating all my savings, how else should I invest my money?"

Invest in mutual funds! See the graph below for FD vs mutual fund comparison.

Return assumptions – FD @ 7%, Debt fund @ 8.5%, and equity fund @ 14%. Inflation assumed to be 8%.

As you can see, investing in Bank FDs will result in less money than you need to keep up with inflation. Debt mutual funds just about manages to beat inflation and equity mutual funds beat inflation with almost 3 times the inflation adjusted amount.

Mutual funds provide professional management of money, are tightly regulated and have proven their performance over time. Mutual funds are also very tax efficient and a little bit of planning can reduce tax on your mutual fund returns to zero (in case of equity mutual funds) or almost zero (in case of debt mutual funds).

Should I invest in equity or debt mutual fund?

Equity mutual funds are recommended for long term investing (more than 5 years) and debt funds for shorter durations.

But even investing in mutual funds can be daunting.

When you decide to start, you'll be swamped with jargon like index funds, diversified, large cap, NAV, etc. It's can be really confusing and most people stop there.

Additional Clarification

Based on the concerns some of our customers raised, here are some additional clarification.

Take a look at how equities have performed over the past several years backed by actual available data.

equity performance

Even though equity is volatile, it has performed better than all other asset classes including FD, Gold, and PPF. No other asset class can grow your wealth as much as equities.

Since direct equity investing is riskier and time consuming, we recommend investing in equity mutual funds which is professionally managed by a fund manager.

If you want a less volatile option, you should choose debt mutual funds. They are less volatile and more tax efficient than FDs. While returns will be lower compared to equity, they still provide better returns than FD and also manages to beat inflation.

I want regular income…

If you want your investments to give you regular income, still debt funds are better than bank FDs due to the long term tax efficiency. You can keep withdrawing from your debt fund corpus or set up automatic withdrawals instead of relying on the monthly interest payout by the banks.

But mutual funds are risky…

Yes. Mutual funds are subject to market risks. However, over the long term, equity mutual funds have shown to provide phenomenal returns.

For minimizing that risk with mutual funds, you should invest in Systematic invetment (SIP) and withdraw in Systematic Withdrawl method. Read about that here: http://drkhalid.blogspot.in/2014/08/how-mutual-funds-hide-bad-performance.html

The above link aslo show how MFs hide bad performance.