If I say to choose between 2 best fixed income investments, one is yielding 10% return and the other is yielding 15%, a novice would certainly choose the latter. But an investor with prior experience would also note the risk associated in these portfolios. All the investment options rate of return is divided into two parts, the risk free return and the risk premium. So the excessive return is the risk premium that we earn over the risk free rate. We can also summarize all the above information in a simple formula-
High return= Risk free rate+ Risk premium
Currently, a risk free return of 8.5% can be seen on a 5 year FD in India.
Now coming back to question asked initially, if we compare them-
The one yielding a 10% return= 8.5% risk free return + 1.5% risk premium
The one yielding a 15% return= 8.5% risk free return + 6.5% risk premium
So to sum up the above calculations above, a conclusion can be made out that a return which has a higher rate also comprise a high risk.
An individual will now choose the first option from the best fixed income investments above.
This poses a very serious problem; no individual will now want to invest in a high return investment. But still people are falling for it; this is because the ratio of risk coming effective is very less to the probability of earning the return. This somewhat depends on your investing and stock knowledge and little bit on your luck too. You cannot control the risk fully. One thing you can control is diversifying your investment portfolio. This is a very rational approach taken by investors nowadays which is popularly practiced as mutual funds.
Mutual funds are a collection of investment portfolios where your investment amount is put into different investment options, so if one option fails to deliver the result then the loss would be negated by the other invested option. The average return here would be 8%-10%.
A relatively new concept is peer to peer lending. It acts as a platform where the lenders could directly meet the borrowers and the intermediary like banks and lending institutions are cut which use to suck out returns from the two parties. The best part in this platform is that the lenders are allowed to invest in multiple borrowers at one time, this diversifies the lender’s portfolio and the invested amount is distributed to many borrowers which reduces the risk significantly. The rate of return is always high and you can expect it up to 24%.
Peer to peer lending is posing as one of the most productive and one of the best fixed income investments and in the coming months it will be the talk of the investor world, and banks may lose sight of gaining investments.