How Much Diversification is Enough?

Lending Club diversification of investor notes

On Lending Club’s home page they talk about the 800 Club (as you can see in the graphic above) – those investors with 800 or more different notes. They proudly state that no investor with at least 800 notes in their portfolio has lost money.

Prosper makes no such claims but because of the way they record their loan and investor data we can actually work this out for ourselves. I fired up Lendstats and ran an analysis on every investor to see the impact of diversification on ROI. Keep in mind that these numbers are only for Prosper 2.0 loans – only investor results for loans invested in from July 2009. The table below shows the results.

Number of NotesWorst ROIBest ROIMedian ROINumber of investors
50-39.9%30.0%8.2%4,884
100-13.7%26.5%8.2%2,705
250-0.8%22.0%8.3%941
5001.1%20.4%8.8%342
7505.1%20.4%9.0%189
10005.4%17.3%8.9%110
15006.8%17.3%9.6%34

Not surprisingly, if you invest in just a handful of loans you can get wildly different ROIs. But what is most interesting to me about this chart is that the worst ROI gets consistently better the more loans you have. Once you get to 500 loans every investor on Prosper is making money. In fact, the second worst ROI (after the 1.1%) is 4.7%.

It Takes 500 Notes to Be Fully Diversified

When investing with Prosper if you have 500 notes it doesn’t matter what criteria you use you will likely generate a positive ROI. You have the law of large numbers working for you – this negates the impact of bad luck and bad choices.

Of course, for many investors having 500 notes is just a dream. With a $25 minimum you need at least $12,500 to have a portfolio with that many notes and this will be beyond many people. Even so, this is something you should work towards. As you can see the more notes you have the less likely you are to have a negative ROI.

Large Investors Take Note

Once you get to 750 notes I would say there is no need to diversify any more. While there may be a small advantage in having 1,500 notes over 750 notes it is not big enough to warrant the extra effort in my opinion. What I would do after you get to 500 notes is start increasing your note size. I would reinvest at $50 per note and if you add new money do the same.

Which brings me to my final point. If you are intending to put a large amount of money to work I say there is no need to aim for an initial portfolio of more than 500 notes. So if you invest $100,000 then you could allocate $200 per note quite comfortably.

What do you think? Is 500 notes the magic number? Please share your thoughts in the comments.

 

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Jeff
Jeff
Jul. 22, 2011 11:32 am

My thoughts… As LendingClub continues to tweak underwriting and the economy improves it may take even less than 500 notes as you’ve discovered here. The lower the better for people sitting on the fence about P2P lending.

Mikael R
Jul. 22, 2011 12:25 pm

Dear Peter,

Great Post. I ran a similar analysis for Peerform investors a few weeks ago and my computation resulted in slightly different figures. I only used Lending Club statistics as I was interested to analyze notes coming from “Prime Borrowers”. Are you able to separate the data from Prosper and LC and publish the numbers? I would be interested to see if our figures converge.

Best,

Mikael

Bilgefisher
Jul. 22, 2011 12:54 pm

Only one item I would add to your article, liquidity. Selling larger notes on folio is likely more difficult (obviously $50 isn’t large, but $200 might be for many bidders). Time vs liquidity vs diversification.

What is also interesting is the number of lenders with less than 50 notes. Currently the post relaunch lender field exceeds 20k. (In fact they just went over 20k lenders this week based on my observations through lendstats.) That means over 1/2 of all lenders have less than 50 notes. They should expect wide variation in results.

The average age of loans will also have an effect on long term ROI. If a lender has 50 notes all 1-2 month old with several defaults, s/he has a very negative ROI. As other notes pay up over time, they could very easily have a long term positive return.

Jason

Mikael R
Jul. 22, 2011 2:24 pm

This is correct, but you can simulate an investor’s portfolio using LC Data: By taking on for every single loan: Total Amount Funded, Remaining Principal, Interest Paid and Loan Status (Defaulted/Charged off or Current). That should create a database of approx 30,000 loans. Then you can create some kind of script that automatically creates 1,000 simulations of 10, 20, 50, 100 and 500 notes and see the distribution of Defaults and ROI.

Mikael R
Jul. 22, 2011 2:46 pm

I believe that most investors do with the “portfolio builder” tool. Let’s connect next week and I will send you my work.
Thanks!

KenL
Jul. 22, 2011 8:32 pm

I have one problem with all the talk of diversifying. Someone with 500 or more notes does not necessarily have good returns because of the large number of notes. I think in many cases the causality is the other way around. A person invests in so many notes because he or she is already getting good returns. People who are getting bad returns stop investing before ever getting to 500 notes invested.

KenL
Jul. 23, 2011 12:49 pm

I think 300 is very well diversified.

Dan B
Dan B
Jul. 23, 2011 4:00 pm

I seriously doubt that the average NEW investor at LC is $9000……………considering that the average investor’s balance at LC is only $8640.

Charlie H
Charlie H
Jul. 24, 2011 10:25 am

Based on the min amount for LC Prime Accounts being $5,000 Lending Club must believe that 200 notes is the minimium notes required for them to show the client a positive ROI.

Brian B
Brian B
Jul. 24, 2011 5:06 pm

I don’t think the $5000 limit for Prime has anything to do with diversification. They only charge .8% in order for them to do all the work. On $5000 that is only $40. Already not much money – but think if you only invested $500 and wanted Prime service, they would be doing all the work for only $4. Even if the system is fully automated, that hardly pays for the electricity their computer uses while it makes the picks and sends you the emails. Let alone any human interaction you require. It’s just not worth their time and effort for so little.

(and I’d also reckon that they consider the exclusivity a bit of a selling point also. Maybe somebody was going to invest $2500…but ooh, I have to invest $5k then I can get a ‘prime’ account…that sounds special and I wanna be special…ok i’ll invest more money)

MikeE
Aug. 10, 2011 4:42 pm

I did an analysis similar to what Mikael R suggested and published it at
https://smartpeerlending.com/posts/loan-diversification

I used only loans that had reached full term. So this is based on actual loan performance and not an estimate.

The simulation showed that any random portfolio with at least 200 loans would have positive net return.

RAS
RAS
May. 31, 2012 10:59 am

is there such a thing as “Too Much” diversification in an acct at LC or Prosper?

ie–is 2000 loans too many?

FredL
FredL
Feb. 8, 2015 2:31 pm

I am novice investor. Do you mean if I diversify to 750 loans, the risk of invest in all lowest grade (ie the highest interest) loans will be fine? I am more interested in what percentage of each different grade has the highest risk adjusted return.

kya
kya
Feb. 13, 2015 5:47 am
Reply to  FredL

even 750 loans in the lowest catagory would bring a positive result…just be ready for a bunch of defaults