3 Rules to Follow When Investing in Peer Loans
Hey guys! Today we’re happy to have a guest post by Joseph Hogue, CFA. Enjoy!
Growth in peer lending as a source of borrowing this year has only been eclipsed by its growth as the new asset class for investors. It took peer lending platform Prosper nearly a decade to originate its first $1 billion in loans. It originated its second $1 billion in just six months this year. Institutional and regular investors have rushed in to enjoy portfolio returns upwards of 10% on a diversified mix of loans.
I get calls and emails frequently from new investors wondering about the risks in peer lending. Memories of the subprime bubble are still fresh in their mind and they are understandably skeptical. Asked about what rules they should remember when investing in peer loans, I reply:
- Understand diversification and how many loans you need
- Understand your own tolerance for risk and need for return
- Understand that peer loans are not a get-rich-quick investment
I’m guessing that your reaction is probably similar to those I get from other investors, “But those are the same rules to follow in any investment.â€
Despite its novelty, investing in online loans is really no different than doing so in other asset classes like stocks and bonds. Following these three simple rules will go a long way to making your investment in peer loans a success and in helping you reach your financial goals.
Peer Lending Rule #1: Understand diversification and how many loans you need
Diversification works for peer loans just like it does for stocks and bonds. Investing in many loans means that a default in one or a few will not significantly affect the return on your overall portfolio.
Investors can put as little as $25 towards each loan they select for their portfolio. This has led many sites to recommend portfolios of hundreds and even thousands of loans to achieve diversification. You can see from the graphic below that this is just not necessary. The chart shows investor returns by the number of loans in the portfolio. After about 200 loans, the diversification benefit from adding any more loans is next to nothing.
Targeting more than 200 loans in your portfolio means you will probably have to relax the criteria with which you pick loans, i.e. invest in loans of lower quality. You won’t be getting much in the way of additional diversification, but you could very well see a lower return on more defaults.
Peer Lending Rule #2: Understand your own tolerance for risk and need for return
Just like with stocks, the urge to jump at the promise of high returns can be tempting but it is not without its share of risk. The table below shows data on loan rates, the loss rate and ultimate return for each credit-risk rating category for loans originated on Prosper.
I have talked to many a peer lending investor that started their experience out by investing exclusively in the highest-risk categories. Their enthusiasm for the investment quickly fades and turns to panic when defaults start to mount. They end up avoiding even looking at the account and close it after their loans mature.
Understand that, even with returns above 10% after losses on defaults, the higher-risk categories are not for everyone. If you get skittish at the thought of market volatility in stocks, what will happen when a borrower stops paying entirely on a loan in which you invested a thousand dollars? Most investors do not need returns of 10% to meet their financial goals anyway. Investing in loans across the three safest categories produced a return of 7.1% and a default rate of just a few loans in 100.
If you are comfortable with a higher number of defaults, feel free to invest deeper into the risk categories. Notice though that higher defaults in the riskiest categories start to eat away at the additional return across all the loans in the category. A strategy of picking loans based on important criteria can help avoid the higher defaults but you still need to be ready for higher volatility.
Peer Lending Rule #3: Understand that peer loans are not a get-rich-quick investment
Trading in peer loans, i.e. buying and selling the loans from other investors, is just starting to open up through brokerage firms. Like many other investments, this will attract people looking for easy money and a way to strike it rich quickly.
Like most get-rich-quick schemes, these fools will be the first to be parted from their money. Whether trading peer loans or just directly funding the loans and holding them, peer lending will not make you rich overnight. The new investable asset class offers a great opportunity to diversify your portfolio of stocks and bonds and average returns that will help you meet your financial goals. There are loan-picking criteria that help to produce returns over the average. I interviewed an investor recently on the blog that has earned a 14% average annual rate over the last five years from using a select few criteria.
Whether you are new to investing or just new to investing in peer loans, remember the three rules above wherever you decide to put your money. Growth in demand for peer loans and as an investment promise to make the industry a significant part of America’s financial backdrop over the coming years. Understanding how to invest in this new asset class will go a long way to making your experience a profitable one.
Peerloansonline.com is your first stop into the world of peer lending. Whether a borrower or an investor, you’ll find everything you need to make your experience a success.
James is an internet entrepreneur, blogging junky, hunter and personal finance geek. When he’s not lurking in coffee shops in Portland, Oregon, you’ll find him in the Pacific Northwest’s great outdoors. James has a masters degree in Sociology from the University of Maryland at College Park and a Bachelors degree on Sociology from Earlham College. He loves individual stocks, bonds and precious metals.