Is This a Common New P2P Investor Mistake?

Most of my friends know I am involved in this peer to peer lending thing. Many think it is strange and they don’t really understand it. Others just think there must be some catch to earning such great returns and dismiss it. But some people are curious and decide they want to give it a try.

This was the case with a friend I had lunch with last week. She proudly told me she had just made her first p2p lending investment. After chatting with me some months ago she had decided to take the plunge and transferred in $5,000. She was fully invested in….get this….eight different loans at an average investment of $625 per loan. I just about fell off my chair.

Now, she hadn’t spent much time reading my blog, unfortunately, because otherwise she would have known what a really bad decision this was. With a $5,000 investment she should be invested in a minimum of 100 different loans, preferably 200 loans. So what made her think it was ok to invest in just eight loans?

The False Sense of Security of the Projected Return

Above is a screen shot of the Lending Club summary page you receive when you have created an order and are about to place an investment. Here the average interest rate of the loans in this investment is 14.65%. There is an expected default rate of 2.61%, an investor service charge of 0.7% which leaves a projected return of 11.34%. My friend glanced at this screen (it was a Lending Club investment) and thought it meant if this particular loan defaulted she would still receive a return of 11.34%.

Now, when you invest in a loan on Prosper (see the screen shot to the left) you are presented with an effective yield, estimated loss and an estimated return. But you can see the asterisk here and if an investor bothered to read the fine print they would realize that this is an estimate based “on a basket of loans with the same characteristics as this listing.” On Lending Club there is no such asterisk or explanation.

I realize you cannot stop people making bad investment decisions but maybe there should be a warning or something for investors like my friend when they are making an unwise decision. But with all the SEC restrictions both Lending Club and Prosper are restricted from giving investment advice so a warning like this might fly in the face of that.

Getting back to my friend. When I asked her why she only invested in eight loans she responded that she didn’t want to spend all day reading the loan listings. She was looking at the listings one by one and deciding whether to invest or not based on what people said in the loan descriptions. She felt attracted to certain loans and wanted to help these people so she put in a significant sum comforted by the projected return number.

We have agreed before she puts more money into p2p lending that she will call me and we will walk through the investing process together. For now, I will probably recommend she put these loans up for sale on the trading platform. She will likely have to take a 3-5% loss on them because large notes are difficult to sell on Foliofn. But that is going to be easier to recover from than a possible default that could see her portfolio take a 20% hit.

Now, I am sure that she is not the first investor to misunderstand what projected return means and she likely won’t be the last. Are changes needed here? I am interested to hear what you think.

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Bilgefisher
Sep. 12, 2011 12:04 pm

I see another issue. “She felt attracted to certain loans and wanted to help these people”

While this is noble of her, its also foolhardy. Emotion should never play a part in your investments. Its a sure way to trouble. I could care less about sob stories on P2P. Are they real, made up, excuses etc? How can you possibly know. The only thing I use the comments for is to back out of a loan. Often times borrowers will give away to much info. Ie: just lost my job and need this till I find another.

Its almost entirely a numbers game. Same with diversification into multiple loans. It doesn’t reduce your risk per loan, but reduces the magnitude of swings in your portfolio.

Jason

Brian B
Brian B
Sep. 12, 2011 5:44 pm

No, I think this is one of those things that people who understand it don’t need the extra information, and people who don’t understand it wouldn’t bother to click on the asterisk and spend the time learning about it anyway.

I’ve spent some time as a poker coach, and this reminds me of teaching poker players about Expected Value, ie sometimes it is a good decision to call a bet even if you think you are going to lose (if its a small bet in a large pot you might only need to win 1 time in 5 for it to be a good move for example). Anyway – students typically understand this concept naturally and immediately, or even with much teaching in a variety of methods they still don’t get it.

The problem is there is no concise way to explain these things to someone who neither knows nor cares. Any 1-2 sentence explanation will be insufficient. Any paragraph+ explanation will look like fine print, and most won’t bother reading it.

obviously i’m generalizing, there’s gonna be some people in between who it might help…but i venture to say that to most, any aid or explanation will fall on deaf ears.

Mike
Mike
Sep. 12, 2011 6:15 pm

Yikes! As Will Rogers said, “A fool and his money are soon separated”. I feel badly for this new investor, and hope that she can sell her notes soon. It never ceases to amaze me when people scrimp to save a couple of bucks in the supermarket, and then sink thousands of dollars into a stock or other investment without doing any research. I hope she finds the time to review your blog before she reinvests her funds.

Dan B
Dan B
Sep. 12, 2011 6:30 pm

I’m sure that you Peter must spoken about diversification, risk & all that other stuff when you spoke to her previously about p2p. Yet it almost sounds like she perhaps didn’t understand, remember or believe you. But I think Brian B. hit it squarely, as it sounds like she really couldn’t be bothered whether you put an asterisk or not. Most people are pretty excited about a new investment. Your friend’s attention span seemed to suggest that her excitement started to wane after 30 minutes or something like that.

I’m just surprised that you didn’t try to steer her towards a hands off Prime Acct…………..given that I assume you know this person’s propensities & dare I say impatience at learning the method.

Charlie H
Charlie H
Sep. 13, 2011 9:44 am

Amen brother.
People who spend hours trying to save at the margins but then will not spend 30 min to save thousands on a large purchase or investment.

People who will stock on up Item X because its on sale, but buy a new car every 3 years.

Penny wise, dollar dumb.

David J.
David J.
Sep. 14, 2011 1:08 pm

While your friend’s investment strategy could have been better, I’ve certainly heard of worse investment decisions. Let’s assume that she invested the same amount in each of the eight notes: $625 per note. If one note defaults right away she will have lost about 12.5% of her investment. Many investors, myself included, lost more than that in the stock market during the last couple of months.

If I were her, I would be inclined to just ride out her first eight notes to maturity and hope that none of them default. There is some risk, but the fortunate thing is that she started with a relatively small investment.

With that said, she should definitely invest in $25 or $50 increments as she invests more money in P2P lending.

Dan B
Dan B
Sep. 14, 2011 6:39 pm

Peter…………One reason why people spend more time researching a fridge versus a stock, mutual fund, or a p2p note for that natter, is because if you know what you want in a fridge & do exhaustive & intelligent research………….the chances of you making a bad choice is close to zero. On the other they can do all of the above on an investment & still get it wrong. After all they see “professionals” who supposedly understand get it wrong all the time. Nothing they do can really get that risk even remotely close to zero & since they don’t really understand what they’re doing anyway, why put in all the work? Besides, a little knowledge can be very dangerous.

Thar’s why my recommendations these days are simple. If you want to invest then do a Prime account & expect 6-7% long term. Or (if the amount is large enough & the person isn’t a control freak) let me run it for you & I’ll get you at least 10% long term. No more long & free explanations about p2p from this guy.

Roy S
Roy S
Sep. 15, 2011 4:29 pm

“she didn’t want to spend all day reading the loan listings.” I hate to stereotype, but I see this type of behavior more in women than in men. It’s not that they’re not capable, it’s that they’re disinterested in it (money, the stock market, investing, etc.). I really think that she is a prime candidate for a PRIME account. I also think this is where LC should be trying to expand with their PRIME account, since they currently have an edge over Prosper which doesn’t have such an option yet.

“with all the SEC restrictions both Lending Club and Prosper are restricted from giving investment advice” Easiest solution: no single note investment can be greater than 10% (or 5% or some other percentage) of your entire investment portfolio. Obviously the percentage would have to be tweaked and at 10% they would have to make the single note investment $25 for all balances under $250. This would be a straight rule and not investment advice, like their minimum $25 investment per loan.

Roy S
Roy S
Sep. 15, 2011 4:30 pm

*This would be a straight rule, like their minimum $25 investment per loan, and not investment advice.

I moved the modifying sentence so it makes sense.

Roy S
Roy S
Sep. 15, 2011 4:32 pm

I meant “modifying phrase.” I vote for an edit option for my comments!

Roy S
Roy S
Sep. 16, 2011 11:26 am

“It is a fine line between protecting people from bad decisions and giving people the freedom to choose.” I don’t consider it protecting people from bad decisions. I view it as protecting the platform protecting itself. It wouldn’t surprise me with how litigious our society is if someone were to end up suing them around this issue. In addition, they need to calculate the risk of someone sinking half their portfolio in one loan that goes bad. If someone has a bad experience, they are less likely to increase their investment and more likely to give negative reviews when talking to friends. I would say to them that if they are listed as friends or family (where on Prosper you need to know the person email address to add them as a friend or family) that the 10% requirement could be waived through an additional step in the investing process.

Roy S
Roy S
Sep. 16, 2011 3:28 pm

, Normally I would agree with your “Buyer Beware” and free market stances. Unfortunately, our legal system hasn’t been normal in a long time. Even if the plaintiff does not win, it still costs LC and Prosper money in legal expenses. Our legal system has come to the point where a package of peanuts comes with the warning that the package may *gasp* contain peanuts! I think that it is a relatively minor cost for a preventative measure against greater legal costs. I wish our society were more in line with your view, yet history tells me that you and I are the ones who suffer the consequences for others’ bad decisions.