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My Biggest Mistake in Peer to Peer Lending

by Peter Renton on December 3, 2010

For Big Mistakes...photo © 2009 Shun T | more info (via: Wylio)I first started out with peer to peer lending back in 2009. I looked at both Prosper and Lending Club but with Prosper in a quiet period then, Lending Club was the only real option available. So I transferred in $500 and started looking at loans.

An hour later after looking at dozens of loans I made my decision. I would invest $250 each in two B rated loans. Big mistake. Even though both these borrowers seemed like a good risk, a few months later one of these loans defaulted and boom, my net return plummeted. By that time I had already put in quite a bit more money and was spreading out my risk more, but even still I found myself in the bottom 10% of Lending Club investors at that time.

Now, I have always considered myself a savvy investor but looking back I realize what a dumb mistake that was. What I should have done is taken that $500 and put $25 in 20 different loans. Then when that loan defaulted I wouldn’t have lost nearly half my original investment. Today, I have recovered to a much more respectable return on my money. That particular account (I also have an IRA at Lending Club) is back to almost an 8% return now. But I have leaned my lesson.

Diversification is Key

If there was only word of advice I could give to every new peer to peer investor it would be this: DIVERSIFY. Don’t do what I did and put your eggs in just two baskets. When you first invest money you should always spread your risk as widely as possible. With hundreds of loans available on both Lending Club and Prosper at any one time this isn’t that difficult. If you find you don’t have the time or inclination to sort through individual loans then choose one of the automated plans. But don’t do what I did and fund just a couple of loans.

Now, you might think after that initial bad experience I would have become somewhat negative on the peer to peer lending idea. Nothing could be further from the truth. I continue to invest more money and I truly believe it is the best risk/reward investment available today.

{ 9 comments… read them below or add one }

Mike December 4, 2010 at 8:42 pm

Sorry you had to learn about diversification the hard way. I limit myself to $25 notes. If I find a particularly attractive loan listing, I will purchase it in both of my Lending Club accounts, as I have an IRA there as well as a regular account.

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peter December 4, 2010 at 8:58 pm

Thanks for your comment Mike. I would rather learn the lesson at the start that have thousands of dollars committed and find out my approach was wrong later. It certainly made me a better Lending Club investor.

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Dan B December 5, 2010 at 4:23 pm

There are however other aspects to diversification that are not as clearcut. In fact some might even find it more than a bit distressing. For example, consider that according to Lending Clubs’ own stats, an investor runs a 1 in 12 chance of earning LESS than a 6% return…………even diversified with over 800 notes! When you lower the diversification to 400+ notes, that risk increases to a 1 in 9 chance! Keep in mind that the real world return is anywhere from 1 to 1.5% lower than anything Lending Club states because they do not include any cash laying around in your account or the funding time on loans when calculating the total return.

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peter December 6, 2010 at 2:37 pm

Dan, You bring up some interesting points. There may be a limit to diversification based on the number of notes available. If you were to invest $10,000 in notes today it may be hard to get the diversification you want. Right now, there are 465 notes available, so for $10,000 at $25 per note that is 400 notes, over 80% of the notes available. I would be curious to do some more research into what you suggest. Thanks for sharing.

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Dan B December 6, 2010 at 6:37 pm

Actually, that’s not my point at all. My point is……………that an investor still runs a substantial chance of returning under 6% even with a diversification of over 800 notes (minimum $20k invested). And considering that Lending Club overstates all returns by 1 to 1.5% due to reasons I’ve already explained………….one has to consider whether the substantial risks involved are worth the potential small additional returns. What substantial risks you ask? Well, let’s start with the simple fact that you don’t actually own a portfolio of loans. You own UNSECURED obligations of Lending Club. Investors should understand the difference. I could go on & on but it’s not my desire to slam anyone unnecessarily. I have been a small investor with Lending Club for 14 months now & I think that the jury is still out on whether it makes sense for “lenders”. I think it’s an unbelievably great opportunity for “borrowers”. I strongly believe that interest rates should be raised for lenders……………..but this won’t happen unless lenders refuse to fund 5-6% loans (which is beginning to occur) because Lending Club makes most of their money on loan originations, which are anywhere from 1-4% off the top of every loan issued.

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peter December 7, 2010 at 3:47 pm

I see your point although I would not say a 1 in 9 chance is “substantial”. Certainly more research should be done, and I intend to look into this some more and will do a post about this in the future. You are right that the jury is still out on Lending Club, it still is not a profitable business and it needs a lot more volume before it becomes sustainable. But, I believe that for those investors earning returns of 10% or more we are being compensated nicely for the risk we are taking.

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Dan B December 8, 2010 at 8:02 pm

The internet is full of people who state returns of 12, 14 even 15% or more returns on Lending Club. These statements are either outright lies or are situations where people have been invested for less than a year……………or most likely, people who hold very few notes (under 150). Simply put they’ve just been lucky so far that . Hell, if this conversation was happening 3-4 months ago, I could come here & claim a 13% return with almost 400 notes held. How’s that for impressive? But none of these are achievable long term numbers & one has to be astute enough to realize this. One must also further realize that conversations that involve spouting return numbers supplied by Lending Club without subtracting the 1 to 1.5% are, shall we say, disingenuous at best. So a 10% return is in reality a 8.5%-9% return. No one disputes this by the way. In fact if an investor doesn’t reinvest consistently you can subtract another 0.5% from his totals. And yet comparisons between LC notes & other investments NEVER make any mention of this & I’d wager serious money that the vast majority of current investors are unaware of this as well. I’m not suggesting that LC is a bad place to invest or that there are any other p2p alternatives that one should choose instead. It’s miles ahead of Prosper imo. I’m just trying to supply some type of balance to the irresponsible cheerleading that seems to be spreading on a very very new type of investment that is somewhat illiquid, has no guaranteed return or even a guarantee that it’s going to be around a few years from now. Add to this that the avg 36 month note now pays 9.4% (LC statistics page) before defaults, before LC fees & before the 1-5% subtraction & I’d love to see how many people can achieve the 10% or more return as you have stated. And that 9.4% is the average of all notes issued & will keep diminishing because I guarantee you that the current new 36 month note isn’t remotely paying 9.4%. It’s more like under 8%. Please feel free to whip out a calculator & go to the site to prove me wrong. I won’t hold my breadth as I wait :)

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peter December 9, 2010 at 3:13 pm

Dan,

Thanks for continuing this interesting discussion. I just ran through the numbers of one of my LC accounts (the one that has been opened the longest) and looked at my statement balance on 11/30/2009 and 11/30/2010. Sure enough my actual return was 6.64%, and LC states that I am getting 7.59%. I reinvest everything a couple of times a month but of course there is a lag in funding notes and not all notes get funded so there is always cash sitting there earning 0%.

I will do a blog post on this later in the month. Thanks.

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Dan B December 10, 2010 at 1:09 am

Up until very recently I was reinvesting 3 or 4 times a week, essentially buying single notes as soon as the $25 mark occurred. It was fun for awhile & just a few minutes a day to do & to look at notes that were potentially going late. I routinely blow them out on Folio at the slightest smell of trouble. In fact I did just that for 5 notes in the last 2 days that were heading into “grace period”. Despite the 40% success rate that LC claims of returning late notes to current……………I prefer to be wary & strongly believe that once it goes late it’s over. Losses from this selling strategy are minimal if at all………….if executed properly. Nevertheless, I’ve still suffered 4 charge-offs in the last 14 months because sometimes you don’t catch it early or no one wants to take it off your hands. So my real world return is now in the 9.5% range & climbing slowly……….with over 550 notes currently
Good luck, Dan

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