peer lending investment diversification

Investment Diversification is a Double-edged Sword

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An understanding of investment diversification can help you earn a high rate of return on your peer loans and minimize the amount of work you need to do in analysis.

Look through any peer lending site for five minutes and you’ll probably see the word, “diversification,” at least ten times. As an investment analyst, the idea of investment diversification has been a fundamental part of my consultations with clients and portfolio managers.

The bird’s eye view of diversification is this, putting all your money in one investment is hugely risky. Even shares of Apple, one of the largest and well-know companies in the world, lost half of their value in just the seven months to April 2013.

Even if your one investment might eventually rebound, most people end up panicking and sell out when prices fall so quickly.

So instead of putting your money in one investment, you spread it around many. Instead of just investing in shares of Apple, you might also buy stock in Microsoft, Johnson & Johnson and many others.

But a stock market crash could wipe out the value in your stocks so you also buy other asset classes, like bonds and real estate. An asset class is a group of investments that react similarly to economic and other factors.

The idea is that if something happens that drives down the value of one investment or even a whole asset class, through investment diversification you will still be able to reach your long-term financial goals because your other investments will not be hit as hard.

Investment diversification is an absolute must in your overall investment strategy but…Here is something you won’t see on any other site.

You can be too diversified in your investments!

Over-diversification is Like Using a Dartboard to Pick Investments

Yes, you can actually have too much diversification in your portfolio of loans for two reasons.

The first problem with the common ‘wisdom’ of investment diversification is that most sites take the idea way too far. I have seen sites recommend starting out with investments of $25 per loan across thousands of loans. This is completely unnecessary and basically a dartboard method of investing.

What do you think would happen if a loan officer walked up to the bank manager and said he was going to invest the bank’s money in an equal amount across all approved applicants? That loan officer would be out on his butt before the manager had time to finish laughing.

There is no way that you could do any form of intelligent analysis of thousands of loans so you’re basically just picking loans out of a hat. Across that many loans, you will diversify away any chance you could have had to pick better performing loans and will be left with the site average or worse.

Take a look at the chart below from Lending Club. It shows the difference in portfolio returns across all investors depending on how many loans in which they invested.

The green line shows the very best portfolios of loans, those top 10% of investors that beat the market. Conversely, the red line shows the 10% of portfolios that underperformed the rest of the investors on the site. The blue line in the middle is the median return across all portfolios.

With very few loans in your portfolio, you could get lucky and see huge returns. Then again, with just a few loans, a few defaults could hit your portfolio and you could be wondering why you even bothered.

Investment Diversification

What happens around 150 loans in the chart is very important. The benefit from adding more loans levels off quickly. If you are savvy enough to find yourself on the green line, adding more loans diversifies away your higher returns. If you are unfortunate enough to find yourself on the red line, adding more loans does not increase your return much.

After more than 200 loans, you are really not adding much investment diversification benefit at all. In fact, each loan you add is just more work you have to do analyzing it so you are only making your job more difficult.

How to Diversify Your Peer Lending Investments

You can still be diversified by spreading your investment wisely across 50 or so loans in a few rating classes. Picking between 125 and 200 loans for your entire peer lending portfolio gives you the opportunity to actually look at the loan application. Most will look the same but I would say about one in twenty present warning signs of a bad investment.

Kicking these out first-hand is the first step to beating the site average and making higher returns.

Don’t think you need to invest the same amount in every loan either. Using a consistent analysis of loans will uncover some that are great investments and some that are only good investments. Invest more in the great loans while investing your minimum in those that just meet your criteria.

Know your risk tolerance and need for return

The second problem I see in investor portfolios of peer loans is the lack of understanding for their own return needs and risk tolerance. Spreading your investment across many different loans and risk categories can lower the risk of defaults but it can also lower the return you will see across the whole group of investments.

Most lending sites and advisors will recommend that you spread your loans across the different ratings, from AA to HR on Prosper and from A to G on Lending Club. This arbitrary method of investing completely ignores your risk tolerance as an investor and the return you need to meet your financial goals.

The table below shows the return for loans on the Prosper site from November 2005 to October 2014.

Prosper Loans and Investment Diversification

If you need a 10% return to meet your financial goals, then you are not going to get it by investing blindly across the highest-rated loans.

But here’s the kicker, you don’t need to invest in AA and A-rated loans to be diversified.

Notice that even with high loss rates on poorly-rated loan groups, the actual return is still considerably higher over the period. With nearly ten thousand C-rated loans over the nine-year period, you can be diversified within the group and still see a high total rate of return. The idea is that by investing in many loans, whether in many risk categories or just one, you minimize the effect that any single borrower or group of borrowers has on the entire portfolio.

Spreading your investments across the middle three rating groups (B, C, D) would have provided an actual return of 10.14% and a 7.7% loss rate. You could have beaten the ‘diversified’ portfolio by more than a percentage with only a marginal increase in risk.

Investment diversification isn’t only about investing across different risk categories, but across different borrowers. Investing in just one rating group can still build you a diversified portfolio if done across enough individual loans. Over a period of years, your return will average out to the long-term average in that group.

The reason many investors do not understand this is because it is different in other asset classes like stocks. Investing in just the companies within one industry, say technology companies, still leaves you at risk of a meltdown in tech stocks like when the market crashed in 2000.

But peer lending isn’t like stock investing. Borrowers in the highest-rated categories are a lot like borrowers in the most risky categories. Instead of being separated by distinct industries or sectors, like with stocks, borrowers fall on a continuum of credit factors and credit score.

This means there is probably less of a difference between borrowers in AA-rated loans and those in C-rated loans than you may think. Any kind of economic crisis, affecting employment and wages, is going to hit all the risk categories. While the highest-risk loans would see a bigger loss, you will still see higher defaults even in the safest categories.

All of this comes down to understanding yourself as an investor. If you are not a person that can watch a couple of loans default without freaking out then you may want to avoid peer lending altogether. Even the highest rated loan group is going to see defaults. But then, if you want to completely avoid investment risk then you would have to avoid stocks and bonds as well. Even bonds, the ‘safe’ investment, saw values tumble in the last few months of 2008.

If you are able to meet your financial goals with a low annual return, say between 5% and 7%, and are not comfortable with defaults then you should stick with the best three risk categories.

If you are capable of riding out defaults without getting overly worried, then there is no reason why you cannot enjoy higher returns by focusing most of your investment in higher-risk loan categories.

One thing investors overlook is the fact that even C-rated borrowers in the table above had a 711 average credit score. That’s pretty decent considering scores only go up to 850. While I would generally avoid the most risky loan categories, there is no reason to miss out on the returns in the middle three categories if you can handle a little more risk in your portfolio.

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Summary:

  • Investment diversification is about spreading your investments across asset classes (stocks, bonds, real estate, peer loans) and across individual investments in each asset class.
  • Adding more than 200 loans to your portfolio does little to help minimize risk and makes your job harder in analysis
  • Understand your tolerance for risk and what rate of return you need to meet your financial goals and invest accordingly in the risk categories for loans

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