Liquid Funds and Short term fixed deposits have two things in common.
  1. They offer an almost risk free method of investing money. They are not as exposed to market risks as other investments like those in stock markets, mutual funds, etc.
  2. The returns on both these investments are relatively low, i.e. just barely enough to beat inflation (most of the times).
Look at this graph which shows historical data of returns given by Liquid Funds and compares it with inflation.

Liquid Funds, Fixed Deposits, Inflation
Note: X-axis of the graph is slightly offset. The chart above is approximate but good enough for a qualitative understanding

Thus you may consider investing in Liquid Funds or (Short term) Fixed deposits if you find yourself in one or all of following situation
  • You have 'free available cash' which you may need after a couple of months or a year. You cannot afford to invest the cash in 'risky investment options' because lets say you already know you need that cash after one year for your trip to europe for example.
  • You want to do better than earning the regular savings account interest rate.
  • If your taxable income is in the highest bracket (30%) you may consider investing in Liquid Funds. Read my detailed post Tax Advantages of Liquid Funds to understand the Tax benefits of Liquid Funds over Short term Fixed deposits.
  • You anticipate that inflation / bank interest rates are going to increase. This is the scenario when Liquid Funds give good returns. Such a scenario is also not good enough to make an investment in stock market or mutual funds because higher inflation can hit company profits and in turn the returns on investments made in equities. It is much better to park your cash in Funds such as Liquid Funds and then make an investment in equities when the inflation fears recede and growth outlook improves.

Also remember that a drop in inflation or an anticpation of lowering of Interest rates by RBI usually hits the growth of Liquid Funds. Such a situation is a good point to exit these funds, partially or completely.

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Oct 16, 2008

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