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Five Lessons Learned from Five Years of P2P Investing

by Peter Renton on June 11, 2014

Celebrating Five Years

Today is the five year anniversary of opening my first p2p lending account. It was June 11th, 2009 when I opened my first Lending Club account. Little did I know at the time but the moves I made back then would profoundly change my career and my life for that matter.

First some back-story. I came across an article about Prosper back in 2008 but by the time I checked them out they were in a quiet period and not taking on new investors. I remember literally tearing the page from the magazine (I think it was Money magazine) and saving it. I kept checking back every couple of months but Prosper remained in their quiet period.

By June 2009 I was getting impatient and decided to do a little research. A simple Google search quickly led me to Lending Club. They were open to new investors so I signed up for an account on June 11th, 2009. The very next day I received this email from Lending Club – my account was open and ready to be funded.

Lending Club Welcome Email June 2009

It was a few weeks before I got around to transferring my money in and making my first loans, so I didn’t officially begin investing until the following month. But five years ago today was the day I decided to give this peer-to-peer lending thing a try.

My Five Practical Lessons

I have learned so much in the last five years that it could easily fill several books. But my education didn’t really kick into high gear until I started writing this blog back in November 2010. Since then, I have written over 500,000 words here and have received at least double that number of words in the comments section. This, as well as the tens of thousands of emails I have received, has enabled me to learn from a huge cross section of people interested in this industry.

But in this post I wanted to distill all this learning down to five key lessons for investors. These are practical lessons for all investors, both new and experienced.

1. The number one rule of p2p lending: diversify

I didn’t understand this lesson when I first started investing at Lending Club. With my first $10,000 I invested in less than 100 loans. When some defaults hit my account my returns went down to the low single digits. What I should have done with that $10,000 is fully diversify the investment into 400 loans – I should have used the $25 per loan minimum to my advantage. This is my number one rule for new investors: unless you are investing more than $10,000 stick to the $25 minimum per loan. This will minimize the impact of any note that does default.

2. Analyzing the loan history can help increase returns

Back in 2009 there were no third party statistics sites that analyzed the loan history of Lending Club and Prosper, although you could do it yourself by downloading the loan history to Excel. Investors are so fortunate today to have several different, easy-to-use options in this area. The leading site today is NickelSteamroller.com and I recommend all serious investors spend several hours on their site learning about the wealth of data available. To help get you started you can read this extensive review from LendingMemo about NickelSteamroller. What Nickelsteamroller allows you to do is analyze the entire loan history of Lending Club and Prosper very easily. You can setup filters on this history to see which pockets of loans have performed the best in the past. You can then use this information to direct your investing today.

3. Higher yield loans have produced the best returns

Once you spend some time on NickelSteamroller you will soon realize that the highest interest (and highest risk) loans have historically produced the best returns for investors. Now, as investors we should realize the past performance is no guarantee of future success and I want to emphasize this one point. If we have a repeat of the financial crisis of 2008-09 or just another recession then it is quite likely that the highest interest loans will perform poorly as a group compared to the lower risk loans. By focusing your investments in the highest interest loans you are essentially betting that the economy will remain in decent shape for many years to come. I invest most of my money this way and I am comfortable taking that risk.

4. Automation is better than doing it manually

When I first started investing most loans stayed on the platform for several days at a time. You could read loan descriptions and ask open ended questions to every borrower you were considering for an investment. Today, those two options no longer exist. While you can still invest manually on Lending Club and Prosper both companies now have APIs that allow for automated investing. You can take these APIs and develop your own order execution system or you can use NickelSteamroller, LendingRobot, Bluevestment or other services to invest on your behalf through the APIs. This allows for a set it and forget it type of investment. I should also mention that both Lending Club and Prosper have their own internal automated investment tools as well but I have found investing through the third party APIs to be superior.

5. An IRA account is the best way to invest

One of the disappointments I have found about investing in p2p lending is the tax treatment. The bottom line is this. All the interest you earn is considered ordinary income but, of the defaults you receive, each year you can only deduct a maximum of $3,000 in losses (assuming you have no other capital gains or losses outside of p2p lending). This will probably not be an issue for smaller investors but for large investors it can really eat into returns. The solution is to invest through a retirement account such as an IRA. This way you can defer taxes (or pay no taxes in the case of a Roth IRA) on the interest earned. For this reason I am only adding new money to Lending Club and Prosper through an IRA.

These are my five practical lessons for investors gleaned from five years of investing. I continue to be focused on these lessons as I turn my attention to my next five years of investing in p2p lending or, as it is now known, marketplace lending.

What other lessons do readers have? As always I am interested to hear your comments.

{ 23 comments… read them below or add one }

Simon Cunningham June 11, 2014 at 12:10 pm

Great piece, Peter. I really loved the Lending Club email from 2009. Makes me want to sign someone up and compare how they’ve changed.

I’m curious how long you stuck with manual investing? I remember doing that for quite a while (mostly with my phone – at bus stops and the like), but when I finally began automating it, it was like a night and day difference.

Also great note about IRAs for larger accounts considering the $3K cap on losses. Bryce Mason mentioned this the last time I spoke with him. It’s something I’ll be paying more attention to in the future.

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Peter Renton June 11, 2014 at 3:13 pm

Thanks Simon. I began using Nickel Steamroller’s automated investing tool in late 2012 and immediately loved it. Not having to login each day was a godsend – my cash drag is negligible these days because NSR keeps me fully invested each day.

As for IRAs, once your portfolio gets above $30,000 or so, depending on how risky your portfolio is, the $3K cap can come into play. Also, if you have other capital losses in your investment portfolio then the cap could come into play much sooner.

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RawRaw June 11, 2014 at 12:14 pm

Just as a side note, Bluevestment isn’t taking new retail customers

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Peter Renton June 11, 2014 at 3:14 pm

Thanks Rawraw, I see that now.

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Eric Gabrys June 11, 2014 at 12:52 pm

Hi Peter,

Great article though I am not sure that analyzing historic data and return brings any long-term value. If Prosper and Lending Club do their job properly (and I think they do), the rate/pricing for each loan should strictly reflect its risk of default. Beating the market is certainly possible but it seems hard to believe that this goes beyond pure luck or a wrong pricing on the loans as defined by peer-to-peer players. Peer-to-peer lending is still an emerging market place where we lack long-term historic data.
That type of temporary mispricing is very likely to be corrected in future loans that they issue. The same thing could be said about stock markets. Trying to beat the market is usually out of reach of most retail investors…I certainly agree that diversification (both in loans AND peer-to-peer platforms) is the key for long-term investor success.

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Peter Renton June 11, 2014 at 3:18 pm

Hi Eric, This an interesting discussion and one that probably needs a separate blog post. I have heard both LC and Prosper emphasize in recent weeks that there is no advantage in analyzing historical loans. I agree with you that mispricing will likely be corrected in the future but the reality is, when you look at the past performance, there have been pockets of mispricing that investors have been able to take advantage of.

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Chris June 11, 2014 at 5:29 pm

“This an interesting discussion and one that probably needs a separate blog post. I have heard both LC and Prosper emphasize in recent weeks that there is no advantage in analyzing historical loans.”

Peter, I wholeheartedly agree that a separate blog post could be dedicated to this specific topic. I hope you decide to take it up or at least point us in the direction of someone who has already covered this increasingly popular topic in detail.

I personally believe the topic of “historical analysis value” will be mentioned/discussed/debated even more in the coming year(s) – and rightly so.

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Peter Renton June 11, 2014 at 8:49 pm

Thanks Chris. This is a complex topic but one I do want to cover at some point. The challenge is that it is always a moving target. Their underwriting models change from time to time and we never know whether the changes are an improvement until a couple of years after the fact.

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Andrew N June 12, 2014 at 6:41 pm

I could have swore that I read an analysis a year or so ago about finding value in historical data that Lending Club seemed to be missing. One example I remember is that you could outperform by selecting loans where the requested loan amount was less than or equal to the borrower’s outstanding loan balance. Of course I can’t find the link now so perhaps I made this example up in my head.

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Peter Renton June 13, 2014 at 5:48 am

Andrew, I don’t remember that specific article but there has been quite a bit of analysis done on different ways to beat the averages.

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NealS June 13, 2014 at 8:53 am

Let’s examine the claim that all listings are perfectly priced to balance return and risk.

Each P2P investor chooses loans according to some algorithm, automated or manual. It may be a simple screen, a complex pricing model, or seat-of-the-pants. For each listing invested, there is an explicit “that’s a good deal for me” decision, meaning that the interest rate offered is high enough to balance perceived risk. For listings not selected, the implication is that the interest rate is not high enough for the perceived risk. As an example, take a listing offering a 10% investor return. All who invest are saying they would have priced the loan at 10% or less. All who don’t invest are saying the listing should have been priced higher.

In effect, we each have an implicit pricing model for P2P loans. Since there is no universally understood model for P2P loan analysis, these implicit pricing models will differ from investor to investor.

Returning to the original premise, we would expect to find that investor returns vary, but only based on luck and investor choice of loan grades. No investor could ever have predictably better returns in the long run. But this is equivalent to saying that no investor can have a pricing model better then the platform’s pricing model. In other words, out of all the pricing models, LC, Prosper, institutional and retail investors; the LC and Prosper models are the best.

Now let’s examine incentives. Investors are clearly motivated by returns to continuously review and improve their methods. By contrast, LC and Prosper have no financial incentive to price each and every loan so that return perfectly balances risk. Their only incentive is to price loans at a rate borrowers will accept and investors will fund.

In conclusion: LC and Prosper have no incentive to price every listing perfectly. Investors do. Some will deploy superior pricing schemes and generate superior results.

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JJ Hendricks June 13, 2014 at 11:59 am

Perfectly stated.

LC and Prosper only have an incentive to change the model if the ratio of non-funded notes to funded notes starts to increase. More notes not getting funding means the market thinks their prices are wrong.

I’m guessing the ratio is heading in the opposite direction based upon my own observations about length of time loans are available.

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Peter Renton June 16, 2014 at 6:21 am

Neal, That is a fair summary and interesting argument, although I would add one point. LC and Prosper need to produce a reasonably fair pricing model in order to attract investors across all loan grades. If they were doing a poor job of say A-grade loans, then these loans would go unfunded and they would lose the revenue from potential borrowers.

And JJ, the loans are ALL being funded right now at Lending Club and the vast majority are at Prosper as well. So, the pricing is certainly good enough for most investors.

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Anil @ PeerCube June 11, 2014 at 3:46 pm

The point #5 “deduct $3,000 in losses” may be misleading. My understanding is that you can deduct $3,000 from your ordinary income after adjusting any losses against capital gains that you may had from all other investments in same year. For example, if you had $10,000 total capital gains from all other investments and lost $13,000 in charged off loans, you can deduct $10,000 of charged off loans against the $10,000 capital gains plus additional $3,000 from your ordinary income. Any leftover capital losses are rolled over to following years to adjust against any capital gains you may had in following years.

I personally do not recommend using IRA for LendingClub/Prosper because of lock-in (difficult to move and associated fees) as wells as liquidation of LC/Prosper loans at reasonable prices and moving the IRA to somewhere else takes extra-ordinary long time that results in cash-drag. In IRA case, investor loses more as IRA offers tax-deferred compounding and cash-drag misses out on it.

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Peter Renton June 11, 2014 at 4:38 pm

Thanks Anil, I realize the tax situation is more complex than I stated but I didn’t want this post to become a taxation lesson. There is a detailed post on taxes here that I encourage everyone to read: http://www.lendacademy.com/lending-club-prosper-tax-information-2014/

Interesting take on the IRA. While there are no fees associated with an IRA as long as you maintain a balance of at least $10,000 ($5,000 in the first year), there is a level of commitment needed. It is not easy to cash out an IRA investment in Lending Club or Prosper, you need to wait until all loans have reached maturity before completely cashing out. But the way I look at it is that an IRA should be an investment that you are committed to – you don’t want to be moving these accounts on a regular basis. I intended to have my IRA accounts at Lending Club & Prosper for at least the next couple of decades until I reach retirement age.

Having said all that a more liquid structure, like a fund, would be a better way to go for an IRA investment. Unfortunately, there is no mutual fund available yet – all the funds in the space right now are only open to accredited investors.

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Bo Brustkern June 11, 2014 at 6:08 pm

I loved reading this post, Peter. A lot of people talk about the transparency you bring to P2P, yet I think P2P is transparent by design, thanks to the good people at Lending Club, Prosper, and now many score others. For you, I’d choose the word *honesty*. Love it. Keep it coming.

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Peter Renton June 11, 2014 at 8:50 pm

Thanks Bo, appreciate your kind words.

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Sean Turner June 12, 2014 at 9:33 pm

Also FYI, on the tax treatment bit if you setup an LLC it can help you avoid the income requirements or asset limitations I deal with in WA state AND since it serves as a separate corporation it neatly fixes my tax issue. So all your losses are localized in the LLC against your profits before it flows to you as an individual for your taxes, so you can neatly work around the $3,000 limit in losses that way, and be able to use those for stock holdings. It cost a few hundred to setup the LLC and a couple hundred for the lawyer to help out get it started, and like 100 a year to renew the llc, but to be able to write off my full 4k in losses in my P2P portfolio AND my 3k losses in my stocks or other assets I think that’s well worth the price.

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Peter Renton June 13, 2014 at 5:51 am

Hi Sean, I am not a CPA or tax lawyer so I can’t comment with any authority on your idea but I would be careful if I were you. What I have heard is this: if the LLC has been setup for the sole purpose of avoiding taxes the IRS will not allow it. If your LLC has other purposes other than investing in p2p lending you may be ok.

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Arnold Miller June 18, 2014 at 11:58 am

Hi,
I liked the article. The $3000 loss limit should be clarified a little bit. At first, it sounds like you can claim the $3K loss, and that you lose out for any amounts over that. That’s not the case. You can only claim the $3000 loss in a tax year. If your losses exceed the $3000, the additional loss is carried over to the following year, where it can be claimed.

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Peter Renton June 18, 2014 at 9:53 pm

Hi Arnold, Clearly, I did a poor job of explaining the $3,000 loss limit, thanks for clarifying.

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Hrant June 29, 2014 at 9:06 pm

Having opened my account in April 2009 w/LC , I fully agree w/all that Peter Renton states in this excellent article, advice.
My only problem, as an investor, even though I am getting 11pct on one portfolio, and 14pct on the other, is that I am spending too much time picking notes, and would love to find alternative pools that have no lock ups, and have proven track records (even if thru past performance using simulated results w/the same criteria).
Hopefully the market will keep growing toward a broader maturity, offering me, along with I am sure others, different investment options to save time investing thru the P2P space.
If there are situations out there that I may avail myself of, please feel free to reach out to me.
Bravo Peter, as usual, for picking up the ball and running w/it since 2009!

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Peter Renton June 30, 2014 at 2:14 pm

Thanks Hrant, good to hear from you. As the industry matures we will likely see many more investment vehicles – some that will likely have no lock ups. Given the fact that there is no real institutional quality secondary market liquidity is still an issue today.

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