In investments, risk and returns go hand in hand. Higher the risk, higher is the return. Or, at least, the expected return. There is a fine difference. The risk you are carrying is of not getting the expected returns. But, the expecta­tion must he commensurate to compensate for the risk. The difference is, since the return is not gua­ranteed, actual returns may be different from the initial expectation.

For any investment, the return expectation and perception of risk has to evolve from somewhere. That comes from history. Any investment category, unless it is just evolving, has a performance history. That gives you the perspec­tive. The investment you are making today is for the future, and future is by de­finition unknown. The on­ly fallback we have is histo­ry. Longer history makes the data more dependable.

When the risk is high, the expected or indicated return is higher, to com­pensate and induce you to go for it. If you are not an expert, you may not have the bandwidth to analyse the intricacies. This is where the ballpark indica­tor comes in handy. The re­turn indication being higher implies the risk is that much higher. You have to decide, up to what level of return indication you want to go. That is where you are setting the risk tolerance for investments. For cer­tain investments, there is a better one-to-one corres­pondence between risk and return. Sometimes, it is not clear-cut.

Let us look at certain in­vestment assets to under­stand the concept.

In case of bank deposits and bonds, there is a better one-to-one correspon­dence between risk and re­turns. Let us say, a leading nationalised bank is offer­ing a term-deposit rate of 6.5%. Then, there is a small finance bank offering 8%.

Higher risk level The implication is, the risk level for a deposit in a small finance bank is little higher than a nationalised bank. Now, let us say there is a local cooperative bank offering 9-10%. Not to say the cooperative bank would default, but the risk level in that deposit is rela­tively higher. The fact that the cooperative bank is of­fering that rate means they are not able to get deposits at, say, 6.5% or 8%. For bonds also, it is a similar yardstick. Let us say there is a top-rated bond from a blue-chip firm available at an annualised return of 8%. Then, there is an in­vestment grade bond from a mid-rung firm for 11%. This is an investment grade bond, but the risk level is relatively higher. If we go higher up the ladder of risk, there are ‘structured credit’ products offering, say, 15%, ‘venture debt’ products offering, say, 20% and ‘distressed assets’ indi­cating, say, 25 or 30%.

Here you haw to decide where you want to draw the line. You may decide to stick to the top-rated hond at 8%. Or, if you are com­fortable with the business house and promoter good­will of the bond offering 11%, you may take a calcu­lated risk. If you have a di­versified portfolio, you would be buying the 11% bond only for a portion of the portfolio. However, if you are not clear about the risks of structured credit or venture debt, it is better to avoid. You got a ballpark idea of the risks involved.

In bonds or debt invest­ments, there is a default risk that can be gauged from the return indicated.

Equity indices

In equity, there is no ma­turity as in the case of bonds, and the return is a function of market move­ment. The gauge we can have is indices and their historical performances. We have leading indices Nifty and Sensex. There are many other indices e.g. mid-cap, small-cap, sector- setc. We can look at the re­turns delivered at the in­dex level and the volatility in the returns. That is the nearest proxy, future can be different. However, for equities there is a tangible basis, though not a guaran­tee. In a growing economy like India, corporates are growing, their revenue and profit are growing and con­sequently, the earnings which you are paying the price for, is growing.

As mentioned earlier, for investments that haw a long track record, it gives confidence about the de­pendability of the histori­cal data. Gold is an exam­ple. Gold as such does not have any productive value.

There is not much of in­dustrial application. Ho­wever, whenever there is ginhal uncertainty, gold prices get bolstered. When staple investments i.e. equity and bonds look ris­ky, investors globally stock up on gold. For gold also, there is no commitment on returns, it is just the histor­ical track record.

In Sovereign Gold Bonds (SGB), there is an in­terest rate of 2.5%, which is committed. However, you invest in SGBs not just for the 2.5%, but the potential upside in returns from ris­ing gold prices, which is a function of market move­ment. You have to be care­ful about any investment that ‘guarantees’ returns’, where the investment basis is not clear. There are plan­tation schemes that would ‘double’ money and ‘depo­sit schemes’ that operate like Ponzi schemes. When the return indication is higher than regular invest­ments, your antennae should move up.

Source: https://www.thehindubusinessline.com/portfolio/personal-finance/return-and-risk-a-ballpark-but-effective-indicator/article67036284.ece