What are the pros and cons of p2p investing and stock investing, and are they worth it?
Back in the day, investing was pretty simple. You could invest in stocks, bonds, precious metals or go out and buy a piece of real estate. These days, there are a wide array of investment options available to us. One of the prominent examples of this is peer to peer lending.
The investment choice is a new one for investors with opinions on both sides. What are the pros and cons of p2p investing and, more importantly, is it worth the risks to move money from your traditional stock portfolio?
What is P2P Investing?
For those of you who are not familiar, peer to peer lending connects borrowers with lenders just like a bank. However, instead of going to a bank for a loan, borrowers can apply for a loan on sites like Lending Club. If they are approved, the loan is split up into $25 notes and investors buy small pieces of each loan.
Peer to peer lending sites have provided both borrowers and investors with an interesting financial instrument. If borrowers are turned down by a traditional financial institution, they may be considered for a loan on a peer to peer lending site like LendingClub.
Investors, on the other hand, are now able to get exposure to an asset class that was traditionally reserved for the banks. You could call it a win-win!
So how to peer to peer lending and stock market investing compare? First, let's consider how money is made with each of these investments.
How Stocks Work to Make You Money
With the stock market, money is made in one of two ways. First, asset appreciation. Also known as buying low and selling high, this is when an investor buys a stock and sells it for a higher price down the road. The other way money is made through the stock market is through dividends. Large, well established companies can opt to share a portion of the earnings with shareholders through dividend payments.
Investors looking for asset appreciation are labeled as growth investors, and investors looking for dividends are labeled as income investors. Some stocks provide some growth potential and dividend income, giving you a little bit of both.
How P2P Investing Works for Investors
With peer to peer lending investment, money is made from the repayment of loans. Let's use Lending Club as an example. Lending Club notes are installment based loans, meaning borrowers must pay interest and principle back monthly. These monthly payments made by borrowers mean that investors will receive payments on a monthly basis as well.
It is important for investors to understand that with each payment they are receiving a portion of their initial principle investment as well as interest earned for that period. Investors who want to maximize their return may want to reinvest their principle in order to keep earning interest on their capital, also known as compound interest.
Main Differences of P2P Investing vs Stocks
That being said, here are some of the main differences between the stock market and peer to peer lending:
1. As a stock market investor, you own a piece of an actual business. As a peer to peer lending investor, you own a collection of debts. In that sense, peer to peer loans are similar to bond investing. A bond is debt obligation.
2. As a stock market investor, you have no idea what your rate of return will be. While you can follow a more aggressive or conservative investing style, returns are unpredictable. With peer to peer lending, you can have a general idea of what your return will be like based on the default rate and the interest rate of the loans.
3. Through peer to peer lending, you are investing in unsecured debt. These loans command a higher interest rate due to the fact that the risk is higher. If the borrower defaults on the obligation for repayment, there is no collateral.
With an auto loan, for example, the bank can repossess the vehicle and sell it at auction to recoup some of the money. With a stock market investment, you own an actual piece of the business and a portion of the debts and assets.
4. Peer to peer lending is relatively easy to understand. You are simply loaning out your money and receiving monthly payments of principal plus interest. The stock market is not as easy to understand. Investing in the stock market as a complete beginner can be a bit scary.
Determining the value of a stock is a complex process, which is why many investors just invest in broad market ETFs instead.
5. The assets do not directly correlate. That is a very technical way of saying they don't do the same thing at the same time. You could see that one year the stock market is negative but you had a positive return from peer to peer lending. This is one of the primary reasons why investors consider peer to peer lending; asset diversification.
At the end of the day, you don't want all of your eggs in one basket. Instead, investors often own a portfolio of stocks, bonds, real estate, gold and maybe even peer to peer loans. If the stock market crashes, for example, you likely will not see a direct correlation with the other assets.
6. If you own stocks that trade on a major exchange like the NYSE or NASDAQ, it is very easy to sell them. This gives this investment high liquidity. Peer to peer loans, on the other hand, are not as liquid. In order to sell the loan, you need someone else to buy it from you.
There is a secondary market where you can sell Lending Club loans early, but investors should commit to holding loans to maturity before investing. It could be difficult to sell loans before the maturity date.
How are Stocks and P2P Investing Similar?
That being said, there are a few similarities between peer to peer lending and stock market investing!
1. Stock market investors can build a well diversified portfolio of individual stocks. Investors on Lending Club, a peer to peer lending site, can build a diversified portfolio of notes. As we mentioned earlier, a note is simply a $25 chunk of a loan. Diversification lowers your exposure to each individual loan or stock, which can help you to mitigate risk within your portfolio.
2. Stock market investors can study the fundamentals of companies and use screening tools when selecting stocks. In a similar way, investors can screen borrowers and select notes to invest in on Lending Club. If you want a more passive approach, you can invest in prebuilt portfolios of Lending Club notes. But for the active investor, you can do your own research and screening.
At the end of the day, we are not saying that the stock market is better or that peer to peer lending is better. Each asset can serve a different purpose in an investment portfolio. The worst place for your money is the bank, where you earn next to nothing. As long as you are doing something with your money and earning some rate of return, you are ahead of the curve. Peer to peer lending could be a way for you to diversify asset classes and be less correlated with the stock market.
Today’s post is by Ryan Scribner, a personal finance and investing YouTuber with over 300,000 subscribers. He also has a personal finance blog Investing Simple where he talks about the stock market, personal finance and different money making ideas.