The risk-reward conundrum is faced by almost all investors around the world. While the financial experts say that higher the risk – higher the return and vice-versa, investors keep looking for investment options that can offer maximum returns with lesser risks. All investments have some or the other risk associated with them, and finding the right options can usually be the difference between a successful and a not-so-successful investor. With technology changing the way we understand the market and investments, there are many newer investment options today which were not present a decade ago. This has added to the already long list of choices available to investors.
Understanding the Risk – Reward relationship
When we invest our money, we expect to earn returns – simple. We don’t want to be bothered with complex ratio calculations or market volatility or a bull/bear run. However, most of the traditional investment options like stocks, mutual funds, etc. are linked to the market. Hence, to be able to make the most out of our investments, we have no choice but to take market-related risks into consideration.
The standard disclaimer provided by most Mutual fund schemes is:
Mutual fund investments are subject to market risks. Please read the scheme information and other related documents before investing.
The important aspect to note here is ‘market risks’. Now, the market is an interesting place and runs on the collective sentiment of investors. So, if most investors feel that the economy might go through a rough patch and start selling, then the market crashes. At such a time, if you, as an investor, are not aware of the ‘market sentiment’ and do not sell, then you expose yourself to the risk of making a loss.
The next most logical question is:
Why expose your hard-earned money to a risk which is way beyond your control and understanding?
If this question was asked a decade ago, the answer would have been simple – there are no other investment options which can offer good returns and are not exposed to the market. However, today the investment landscape is changing at a rapid pace and you no longer need to expose yourself to unnecessary risks in order to earn healthy returns.
Online Peer to Peer Lending
Around a decade back, when digitization was making inroads into all walks of life, fintechs started evolving. These companies offered financial products as an end-to-end service over the internet. These fintechs observed a few pain areas in the financial landscape:
This led to the birth of Peer to Peer Lending – a democratic alternative to the traditional lending-borrowing process. P2P Lending, allows Retail Investors to lend funds to Retail Borrowers without the intervention of a bank or a lending institution. Here is how it works:
The P2P platform assesses the creditworthiness of the prospective borrower and assigns a risk class and range of interest rate to each borrower. As an investor, you can access this information before making a decision of lending funds to a particular borrower. Since the loan is offered without the intervention of a bank, investors stand a chance of earning good returns.
The risks associated with P2P Lending
Remember, when we started the article, we said that investments are always associated with some or the other type of risk. While P2P lending does not carry market risks, it carries a risk of default – that is a borrower who does not pay back.
The main difference between the risk of default and market risk is that while the latter is completely dependent on uncontrollable investor sentiment, the risk of default can be mitigated to a great extent by using the two-level diversification – an inherent feature of P2P lending. Here’s how:
People Lend, one of the trusted names in P2P lending, assigns five risk classes to borrowers based on their credit profiles. Once you decide to invest through a P2P platform, you determine the risk classes that you would want to invest in based on your financial objectives and risk preference. Let’s look at a simple example:
Rajiv decides to invest Rs 100,000 through P2P platforms. He feels that he can take high risk with 30% of the amount and very-low risk with the remaining 70%. Accordingly, he selects Risk Class V (the highest risk class) and Risk Class I (the lowest), to invest Rs 30,000 and Rs 70,000 respectively. Here, he successfully manages to complete the first level diversification.
Now, let look at the Risk Class V investment. Since this is a high-risk bucket, theoretically, the chances of default are high. Now, Rajiv looks at all the loan requests from borrowers in Risk Class V and selects 15 borrowers whom he finds promising. Then, he lends Rs 2000 to each borrower. Hence, he limits his exposure to Rs 2000 per borrower, which is much safer than exposing the entire Rs 30,000 by lending it to one borrower. This is second level diversification.
While the chances of default are high, it is important to note that not all borrowers in Risk Class V will default and Rajiv’s losses, if any, due to default, will be covered by the higher interest he earns from other borrowers in this bucket.
This makes P2P lending a safe investment option with an opportunity to earn higher returns.