P2P investing is bridging the gap between stocks and bonds but you’ll need to avoid the three biggest p2p investment risks
Risk-free treasury bonds are paying nothing after inflation and even junk-rated corporate debt will net you only about 4% after taxes. Stocks have been doing well but won’t go up forever, the next recession promises to send the stock market and your investments tumbling.
It is no surprise that income investors have started to look to other asset classes for stable returns. The number of phone calls I’ve received about p2p investing has doubled in the last three months and everyone wants to know one thing, what are the biggest p2p investment risks and how can they be avoided?
What are the biggest p2p investment risks in peer lending?
When asked about the biggest p2p investment risks in peer lending, my answer isn’t the one usually expected:
- Chasing high returns with no thought to your own risk tolerance
- Not understanding diversification in peer lending
- Not understanding your time horizon with peer loans
When I say this, the reply I most frequently get is, “But that’s pretty much the same as any investment.” Yep, the p2p investment risks in peer lending are basically the same as any other investment. Understand those risks and you could be on your way to very respectable returns.
In fact, I recently interviewed one investor that has earned an annualized 12% in p2p investing over the last 7 years. He’s made over $10,000 on p2p investing without taking on huge amounts of risk and with a simple set of criteria to pick loans.
Peer Lending: A New Asset Class for Investors
Before I go into p2p investment risks, I usually have to convince investors that online loans are a legitimate asset class in the first place. Even after multiple market crashes since 2000, most investors still think they only need stocks and bonds in their investment portfolio.
If you're one of these, you may want to look back a little to see just how well your portfolio has performed over the last twenty years.
According to research firm DALBAR, even though the S&P 500 returned an annualized 9.2% in the 19 years to 2013, individual investors earned just 5% a year. Bond investors didn't even get that. The Barclay’s U.S. Aggregate Bond Index returned nearly 6% on an annual basis but bond investors saw their investments gain less than 1% a year, more than a percent under annual inflation.
The difference is mostly due to panic-selling when the market tanks and euphoric buying as prices go up. Instead of buying low and selling high, lack of investor discipline usually leads to buying high and selling low.
What's the answer to the perennial problem of low investment returns in stocks and bonds? Investors need a new asset class and peer lending is quickly stepping up to fill that role. Loans originated on the Lending Club website over the four years to August 2013 returned an annualized 9.0%, and that is after losses on defaulted loans is removed. Loans originated to borrowers with a B-rating and an average credit score of 729 returned 7.36% with a default rate of just 3.7% on loans.
This isn’t data cherry-picked across a few p2p loans. The return of 9% above was calculated off of more than 75,000 loans issued over the four-year period, at a time when even mortgage loans in the United States were seeing historic default rates.
As of June 30, 2015, the average Lending Club borrower had a FICO score of 699 and more than 16 years of credit history. Average personal income of borrowers was $73,945 with an average loan size of $14,553 per loan.
Sceptics say that unsecured peer loan borrowers will default in waves when the next recession comes but do you really think someone with a 700 credit score and nearly $74k annual income is going to destroy their credit by walking away from a relatively small loan?
Beyond strong returns, peer loans offer diversification from a stock and bond portfolio. Using the S&P Experian Consumer Credit Default Index as a proxy for peer loans, we find almost no correlation (0.014) with stocks over the last five years and a very low (0.28) correlation with bonds. This means that not only can you see higher returns on p2p investing but, combined with a portfolio of stocks and bonds, you will reduce your risk significantly.
Interested in peer loan investing but not sure how to get started? Check out this Lending Club review including how to open an account and how to invest.
P2P Investment Risks in Peer Lending
Once the conversation has turned from, why to invest in peer loans to how to invest in peer loans, the investor again becomes interested in p2p investment risks in peer lending.
P2P Investment risks in peer lending #1: Chasing high returns with no forethought to risk tolerance
The backbone of any investment strategy is your need for return balanced by your personal tolerance for risk. How many investors have jumped into the hot penny stock on the hope of getting rich quick only to lose money after the stock crumbles? There is good money to be made in stocks of small companies but the risk is more than many can stomach.
The same is true for peer lending investors. Too many investors see double-digit rates as high as 30% on loans and put all their money into the high-risk category. Their sense of euphoria and hope for an early retirement soon turns to anguish when loans start to default. While loans in the HR category on Prosper have earned a solid 10.4% annually, nearly 17% of them have defaulted. Risk averse investors sour quickly on peer lending and avoid even looking at their account or close it out once their loans mature.
I’m going to tell you THE secret to success in investing…ready? You don’t need super high rates of return. An annual rate of just 7.5% over 25 years on your portfolio will grow to $163,000 with contributions of just $200 each month. That’s a gain of more than $100,000 over the period and on a relatively modest rate of return!
The problem is that people rush into high-risk investments and end up losing their shirt. They never see that 7.5% annual return and they never see what their life could be like meeting their financial goals. Before starting any investing plan, you need to figure out how much you need in retirement. There are plenty of calculators to figure out how much you’ll need in retirement. I like the retirement calculator on Bloomberg.
Even at the ripe old age of 40, it turns out that I only need to make monthly contributions of $450 and earn 5% annually to meet my retirement goal by the time I reach 65 years old. Knowing that I only need a 5% return, do you think I will be investing in penny stocks and HR-rated peer loans? I can construct a diversified portfolio of solid stocks, bonds and relatively safe peer loans and will likely retire on more than I need.
Lesson: Let your need for return and your tolerance for risk be your guide for picking peer loans. If you need modest returns on the order of 5% to 7% and get skittish over loan defaults, then stick with the first three loan categories. If you need slightly higher returns and can accept higher defaults, then spread your investment out to the higher-risk categories.
P2P Investment risks in peer lending #2: Not understanding diversification
Diversification is the idea that, if you spread your investments out over different areas then some will go up even when others are going down. It’s the principal reason why I don’t worry about a stock market crash wiping out my nest egg. For many investors, this means buying stocks and bonds since the two rarely fall or rise at the same time.
But stocks and bonds alone are not enough. Besides the fact that investors rarely see market returns, there are times when stocks and bonds have both fallen together. Over the four weeks to October 10th 2008, the stock market plunged 27% but bond investors also saw their investments fall by 13% as the debt market locked up after the collapse of Lehman Brothers. So the need to diversify into other investments is clear but some investors take the idea too far.
In peer loans, you can be too diversified as well as not diversified enough.
Not diversifying enough goes back to the first risk where investors jump into one specific category of loans and choose just a few high-rate loans in which to invest. The chart below, provided by Lending Club, shows the difference in portfolio returns by how many loans held in the portfolio.
You can see from the graph that if your portfolio holds less than 100 loans, you are setting yourself up for very good or very bad returns. While you may be able to achieve those stellar returns over a couple of years, the chances are likely that your luck will run out eventually. Beyond the number of loans in which you invest, it is also a good idea to spread your investment out over at least a few loan-risk categories as well. This will give you the benefit of higher rates in some categories and the stability of payments in others.
I have also seen some websites recommend that you invest the minimum $25 per loan across thousands of peer loans. This is what I call the dartboard strategy because basically you are just throwing your money at any loan without a rational investment strategy. This arbitrary system of investing will likely get you returns around the average on the site but you’re leaving a lot of money on the table.
While the entire portfolio of loans on Prosper have provided a strong return over the last several years, there are criteria you can use to lower your risk and increase your return. My interview with one Prosper investor outlined several criteria that have helped him make $10,000 on the site and earn an annual return of 12% over the last six years. In fact, I recommend a portfolio of between 125 and 175 loans to give yourself enough diversification without losing the opportunity to make higher returns on a good loan-selection strategy.
Lesson: Invest in the right number of loans across several risk categories to achieve the right level of diversification.
P2P Investment risks in peer lending #3: Not understanding your time horizon
Just like any investment, you need to understand your time horizon for investing before you jump into peer loans. Peer loans cannot be sold like stocks or bonds. Once you have invested in a loan, it is yours for the three- or five-year term. You can use the regular monthly payments as income but your investment is locked up in the loan.
There’s nothing wrong with using peer loans for income in retirement. I know a lot of people that do this and live very well. The issue is that, if you know you have a big purchase coming up, then you will not want to invest that money in peer loans.
Even as you continue to invest into new peer loans, understand that loan performance can rise and fall with the economy. Even though it doesn’t appear that peer loans will fall much along with stock prices, given stocks’ low correlation with the loan index, there could still be times that your portfolio value will decline before rebounding. Since no one is able to know when these periods of economic weakness may come, it is best to set aside money that you will need in the next three to six months in an account and not invest it in peer loans.
Lesson: Invest only what you can afford to set aside for three- to five-years in peer loans.
A lot more can be said about each of the p2p risks above but it is enough to give you the idea. Investing in peer loans is really no different from investing in other asset classes. I believe that in five years, and probably less, the peer loan market will be a commonly accepted investment idea.
We have already seen financial advisors start to recommend peer loans and people are starting to put them into their individual retirement accounts (IRA) as well. Once you understand the p2p investment risks in peer lending, you are well on your way to diversifying your portfolio with lower risk and solid returns.