Five Lessons Learned from Five Years of P2P Investing

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.

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Simon Cunningham
Jun. 11, 2014 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.

RawRaw
RawRaw
Jun. 11, 2014 12:14 pm

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

Eric Gabrys
Jun. 11, 2014 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.

Chris
Jun. 11, 2014 5:29 pm
Reply to  Peter Renton

“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.

Andrew N
Andrew N
Jun. 12, 2014 6:41 pm
Reply to  Peter Renton

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.

NealS
NealS
Jun. 13, 2014 8:53 am
Reply to  Eric Gabrys

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.

JJ Hendricks
JJ Hendricks
Jun. 13, 2014 11:59 am
Reply to  NealS

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.

James Wood
James Wood
Sep. 21, 2014 11:05 pm
Reply to  Peter Renton

Bowers with say, over 90% debt, don’t do as well as those with less debt. That is what the math says. . . Maybe they will nerf it but until they do. . Also, it is to their advantage to tell you all loans are the same so they all get funded. We know that in the past they have not all been the same. I’m not sure it is possible to perfectly balance risk and reward. And I’m also not sure that the majority of the market is putting in the time to develop and run models that deliver a few extra % points by lowering default rates at a given interest rate range. All I can say is that I’m beating the average in 3 different accounts and I don’t think it is luck.

Anil @ PeerCube
Jun. 11, 2014 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.

Bo Brustkern
Bo Brustkern
Jun. 11, 2014 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.

Sean Turner
Sean Turner
Jun. 12, 2014 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.

Arnold Miller
Arnold Miller
Jun. 18, 2014 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.

Hrant
Hrant
Jun. 29, 2014 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!

Antonia
Sep. 17, 2014 11:44 am

Hey Peter!

Congrats what a great post! I am from Colombia and here in Latin America P2P lending is completely new. I am one of the co-funders of the first crowdfunding reward based Platform for social projects http://www.llittlebigmoney.org and now I am working in the business development of Afluenta.com in LATAM.

“Over 1,000,000 people have already visited http://www.afluenta.com. Our lenders generated 38,000 investment transactions to originate loans worth of ARS$12,000,000 and up to 160 lenders invested within a single loan, demonstrating the power of peer-to-peer financing among Latinos

Afluenta is the only one peer-to-peer lending company in Latin America authorized to operate by a local SEC. The system works through a client segregated account in a ordinary administrative trust ruled by a local law, where investors act as trustees and Afluenta acts as trustee. Loans are granted thru a trust with contributions made by lenders in accordance with their instructions. Afluenta is registered with the Public Ordinary Trustees Registry (Registro de Fiduciarios Ordinarios Públicos) of the National Securities Commission (Comisión Nacional de Valores). That Resolution allows Afluenta to provide public fiduciary services, while being monitored by the National Securities Commission, an entity which neither authorizes nor monitors any fiduciary agreement executed by the trustee*.

Hope you can write in the near future about P2P lending in LATAM. It will be a pleasure, help you with our experience.

Steven
Steven
Oct. 27, 2014 9:17 pm

Can you clarify the advantages of using a third party API over lending clubs automatic investing using a filter?

Jason Jones
Member
Jason Jones(@jason)
Oct. 28, 2014 10:12 am
Reply to  Steven

NealS below hit the nail on the head. The third party APIs are more flexible and have more criteria. For most investors their Automated Investing tool will be fine. But for more serious investors the API is the way to go.

NealS
NealS
Oct. 28, 2014 8:16 am

The investor may wish to use selection criteria that can’t be implemented using filter. As an example, I might want to avoid debt consolidation listings where the requested loan amount greatly exceeds current revolving credit balance. You need an API to do that.