What are the Best Practices for P2P Lending Investors?

I have been wondering lately if there are some best practices for investors when it comes to p2p lending. These would be tried and true ideas that apply to investors whether it be in Lending Club, Prosper, even Zopa (in the UK) or any new entrant that might come into the industry.

Open any finance magazine or talk to any financial advisor and you will hear about all kinds of best practices for investing in various different asset clases. I think peer to peer lending also has some best practices and I share a few thoughts about this topic below.

1. Diversification

This is the most important factor in the success of your p2p investment. Regular readers will have heard me say this many times. You need to diversify your investment. If you invest $1,000 make sure you invest in the minimum of $25 per note. I really think unless you are investing more than $5,000 it is important to stick to the $25 per note minimum. Defaults are a fact of life in p2p lending – if you invest long enough you will eventually suffer defaults so you want these defaults to impact your overall investment as little as possible.

2. Don’t let idle cash build up

One of things that sometimes surprises new investors is how quickly the cash builds up. Once you start investing in loans within 45 days you will see payments coming into your account. These payments consist of principal plus interest so with a fully invested $10,000 account, for example, you can see new cash coming in at the rate of $400-$500 per month depending on the terms of your notes. This cash will sit there earning 0% interest until you reinvest.

3. Understand the risks

There are detailed prospectuses available for both Lending Club and Prosper (those are links to the current prospectus PDF files). They contain all kinds of information including around 20 pages detailing the risks of p2p lending. Now, I realize that few investors will read these before investing (I know I didn’t) but it is still important to have some idea of the risks. I wrote a post a few months ago detailing some of these risks and if investors don’t want to read the prospectus they should at least spend a couple of minutes reading that post. There are also some great comments there which will give investors even more information.

4. Do Some Research

This one is pretty broad. But I think investors should at least do some research before committing their money. I would like to see every investor spend an hour or more looking at the investor information on the websites of Lending Club and Prosper or spending some time doing analysis on Lendstats or Nickel Steamroller. This way you can get some idea of how the system works and what kinds of loans are more likely to produce good returns.

Those are the main ideas I have but I wanted to open this issue up to others. I created this post as a question deliberately because I don’t think best practices in p2p lending have been fully defined yet. What do you think are some best practices that would apply for all p2p investors? Please share your thoughts in the comments.

 

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Chris
Chris
Oct. 14, 2011 12:29 pm

One piece of advice I would offer is to study your defaults closely so that you may learn from them. After you have more than one default you can begin to ask yourself questions such as:

1. What do these defaults have in common?
2. In retrospect did I bend my requirements or change my search filter in such a way that I would not have normally invested in this type of loan?
3. Do my defaults have a similar credit report metric(s), if so, which one or ones?
4. Did I purchase these notes off of a secondary market (Foliofn)? If so, which search criteria did I use to find them?

Our mistakes are often our best teachers should we choose to learn from them and I have found learning from defaults to be incredibly valuable with regard to future investment decisions.

Food for thought,
Chris

Bilgefisher
Oct. 14, 2011 2:21 pm

I still differ on the opinion of diversification. I have the same risk of default whether I invest one note of the same class or 100 notes. Yes, the fewer the number of notes, the larger the swing in your ROI initially. But the swing between owning 100 notes at $25, 50 notes at $50, or even 25 notes at $100 is very little. I just think its a waste of time to focus any energy on diversification. The primary focus should be the maximum return for the risk you are willing to take.

Michael
Oct. 14, 2011 6:54 pm

@Chris
The one thing I am avoiding now are re-lists. I’m also experimenting with excluding states with lower ROI.

@Bilgefisher

If I gave you a die (singular dice) said I’ll give you one try to roll a 3 or six tries, you would obviously pick the six tries.

Diversification allows you to get a very small confidence value for projecting returns. So, diversification allows you to hit your target ROI with greater probability.

At this point I am not buying more than $25 per note. I feel this is the best way to get predictable returns.

Lou lamoureux
Lou lamoureux
Oct. 14, 2011 7:32 pm

Hi Peter,
I wholeheartedly agree that a person putting their money at risk needs to do the research. I disagree that Nickel steamroller and lendstats should be their first or only stop. To truly understand the data you need to do the work yourself. Nickel Steamroller has a blog post about how he had issues with the current credit policy filter and was potentially disregarding 8% of the data. OOPS!

@bilge fisher you invest $2500 in one note that has a 1 in 100 chance of going belly up or in 100 notes each with a 1 in 100 chance of going belly up. If you get unlucky and that $2500 loan goes belly up it’s game over you’ve lost most of your principal. If you are really unlucky and 4 or 5 of those $25 notes go belly up you’ve lost $100 to $125. Diversification is a basic tenet of finance. It’s mathematically proven to work.
Lou

Michael
Oct. 14, 2011 8:14 pm

@Lou
The reason I created Nickel Steamroller was to understand “the data”. I can safely assume most people don’t have the technical skills or time to develop a platform for multi-variant analytics. LendStats and myself are trying to help bring clarity to an ocean of numbers. Peter never claimed “that Nickel steamroller and LendStats should be their first or only stop” for investors. In fact, I believe he suggusted just the opposite. We’ve (LendStats and myself) only scratched the surface of analysis and are by no means a one-stop shop. For instance, this blog fills in gaps our analytics could never fill in. But we are all working together to make p2p lending more transparent, fun, and rewarding.

The assumption on “current policy” was one that I believe almost everyone had. The way you spin it seems like it was mistake due to ignorance or carelessness (indicated by your OOPS!). I take a great amount of time to verify all of my data, ensuring accuracy. I invite people to test my code before I make it live. I could have easily made the change and not made a blog post or notified users. I feel it’s more important to promote better understanding of the data for the entire community which is why I made the post. I hope that I have not turned you off from using Nickel Steamroller. I continue to improve it almost daily and I am constantly dreaming up new ways to visualize the data. My goal is to empower lenders with analytics and build confidence in p2p lending.

Louis Lamoureux
Louis Lamoureux
Oct. 14, 2011 9:21 pm

Micheal,
sorry that wasn’t my intention. I think lendstats is a great site to verify my results. I haven’t used your site much, but I applaud your efforts. A site like lendstats can be a crutch for those who don’t want to do the homework, and if they don’t understand the assumptions the site makes, their investment strategy may be flawed. A flawed strategy is definitely an oops! you’ve built a great tool, but it is vulnerable to an io error.
Lou

Michael
Oct. 14, 2011 9:41 pm

@Lou
Trust me, it would not be the first time a programmer missed a decimal point. It’s a valid concern. If it makes you feel better I use unit testing to verify historical data when I make platform changes. If there is a problem it will show up in the unit tests. You can also monitor the last import for the system here: https://www.nickelsteamroller.com/status

The only reason I found out about the current policy issue is because I flew out to SF to visit LC and Prosper last week to learn more (using my money) and it came up in conversation.

My site is only a few months old, but you will notice every page on the system has a comment section. It’s designed to ease reporting ANY issue with the site’s data or method.

Roy S
Roy S
Oct. 15, 2011 7:30 am

@Bilgefisher, I am another one who agrees with diversification. I think Lou’s analogy works best. If you were to throw a 1 on a die and lose your whole $2500 the odds are 1 in 6 or 16.7% chance. If you split your $2500 into two throws of $1250, the odds of throwing a 1 both times and losing your entire $2500 is 2.8%. Splitting it in thirds will give you the odds of throwing three 1’s and losing the entire $2500 at 0.4%. The odds of losing all your money the more you split it up into different notes goes down dramatically even though your expected returns remains the same. It is all about reducing your odds for significant losses rather than increasing your returns. Obviously, you do also reduce your odds for significant gains, too, when you diversify.

@Michael, I appreciate your efforts. I think I’ve only visited your site 2 or 3 times as I have gotten used to working on Lendstats, and I believe your site was only up and running for LC at the beginning. I should probably take a swing over to your site more often, though.

What I am beginning to think about and the direction I’m thinking about taking in my investment strategy is to start focusing solely on defaults. I think I’ve been focusing too much on returns and not enough on defaults. With Prosper’s change last Friday/Saturday, it reminded me that Prosper is still manipulating the expected returns. The most recent change announced was moving repeat borrowers into a higher grade/lower interest rate. Using historical data for this subset of borrowers, the returns will look higher than what one would now expect to achieve if they were to invest in this subset (i.e. historical data for returns is moot). Whereas the grade and the interest rate are dependent on Prosper, the default rate is less dependent–assuming everything else being equal, it is easier to pay back a $20,000, 36-month note at a 20% interest rate rather than at a 25% interest rate so just in assigning an interest rate Prosper can affect the default rate. I still haven’t fully thought through and developed a new strategy, but I’m hoping the more I can reduce my default rate based on variables independent of Prosper the more I can increase my returns based on the variables dependent on Prosper.

Louis Lamoureux
Louis Lamoureux
Oct. 15, 2011 8:29 am

@ Micheal, I spent a lot of time doing tech support “IO error” is code for Idiot Operator (those people who call in saying the program is not doing what its supposed to, then we tell them RTFM). These are the same people that need a cup of McD’s coffee to have a warning that says coffee is hot. Which reminds me, I saw in the news someone is suing the producers of the movie “DRIVE” because there wasn’t enough driving in it. You should put a splash page on your site with legal stuff to protect yourself from these people.

@Roy S much more elegant explanation of diversification. Also, I didn’t look at returns as a part of my analysis until I found lendstats. I would check to see how many defaults there were for a given filter and expressed that as a percent of all the loans in that filter. I suspect, but can’t prove, that looking at returns can skew or mask certain filters in favor of the higher interest rate loans.
Lou

Charlie H
Charlie H
Oct. 17, 2011 2:08 pm

Is it possible to be over diversified?

Bilgefisher
Oct. 17, 2011 3:08 pm

Whats interesting is I never said to invest $2500 in one note. I can agree on foolhardy nature of betting it all on red. Rather I’m saying there is statistically very little variance between investing 25 $100 notes or 50 $50 dollar notes. Quit wasting time concentrating on “diversification” and searching those extra notes out. Spend your time honing in on the right type of notes.

Jason

Roy S
Roy S
Oct. 18, 2011 10:55 am

@Bilgefisher, You were comparing more than just 25 $100 notes to 50 $50 notes. You also shrugged off 100 $25 notes as being statistically insignificant. The issue again is whether (for whatever reason) the notes you pick have a greater default rate than the average. The greater the number of notes you pick, the lower the probability of straying from the mean, whether your mean is a 5%, 10% or 15% reutnr. You could have the best strategy, but it doesn’t protect you from defaults. If your strategy has a bucket of 100 notes where only 3 notes of that 100 would default, and you only pick 25 $100 notes and all 3 of the defaults end up in your picks you will suffer a greater default than if you were to pick all 100 (assuming the notes are of equal size). I don’t think you can state that people shouldn’t concentrate on diversification and then blow it off when challenged. If your strategy is to pick fewer notes, that is your strategy. I agree that people should focus on “honing in on the right type of notes,” but unless you are prescient and can predict defaults, the best way to lessen the impact of any single note defaulting is to spread your risk through diversification. Even if you are able to hone in on the right type of notes which produce a 20% return overall, why risk not diversifying and only achieving a real return of 5% because you happened to have defaults over-represented in your portfolio?

Bilgefisher
Oct. 21, 2011 9:25 am

@Roy
Sorry missed your reply from earlier. These are great discussions for the forums. Easier to track. I am rather enjoying the arguments btw.

I don’t believe I understand your statement that I am blowing it off when challenged. I can agree with everyone, if you have $500, 5 notes can see 5 defaults even with a statistical default rate of 3% via similar loans. Truth is, there is a far greater chance of none of them defaulting. As 1 in 30 are only likely to default. I use to be a poker geek. EV was more important than short term gain or loss.

Lets go back to the example of $2500 invested. Even if folks have a refined investment criteria it will still take 4 times as long to invest in 100 notes at $25 then 25 notes at $100. 1-2 minutes per note doesn’t seem like much till you do it over 75 more times. I assume that most folks will continue to add money over time. As that $2500 becomes $5000 or $10000 the time commitment really adds up. During that time your note default rate gets closer and closer to the average default rate for the type of notes you invest in.

Basically it boils down to this for me. I would rather not spend that extra time looking at notes just to keep my variance low when in the long run it will level out anyway. I can respect your and Peter position of lowering the variance. To me its a waste of time. I suppose we’ll have to agree to disagree.

Jason

Roy S
Roy S
Oct. 21, 2011 4:01 pm

, If your assumption holds true, and people do add more money to their account then they will naturally diversify their holdings. I would agree that some people do add money, but I think others may just sink $5K in and leave it be to see what happens. For these people, the best practices for them to adhere to is to diversify because they aren’t continually adding to the portfolio which would diversify their holdings naturally. Because you are diversifying your portfolio every time you add to your position, trying to diversify a lump sum of $2,500 isn’t worth the extra time because that is only your initial investment. You might add another $25K over the course of the year.

The whole point of diversifying is to reduce the variance. Otherwise, the returns will be more volatile and and possibly put you in negative territory. For someone who hasn’t done their DD, I would always strongly recommend them to diversify. I do agree with you that it will take more and more time as your portfolio increases even with the saved searches function on Prosper. What I am not saying is that if you have $100K that you should only invest $25 per note, but I wouldn’t recommend investing $4K in 25 notes either. Really what it comes down to is knowing how much variance you can tolerate, which varies from person to person. For a lot of people who don’t know much but see this as a good investment, they may not fully understand the risks so, in my opinion, it is always a good idea to over-emphasize diversification to them. You are right that your variance will level out in the long run (especially if you keep adding to your position), but I do think there are a lot of people who are focused on the short term and therefore have a lower ability to handle a larger variance if it starts to go negative for them. These are the panic sellers in the stock market who don’t understand the best practices of DCA. I don’t want to be the one to tell them not to diversify, have them have defaults over-represented in their portfolio, and then have them withdraw their money and stop investing while showing a 10% loss or more.

Jon Smith
Jon Smith
Oct. 23, 2011 3:22 pm

,
I agree, but I think the amount invested per loan is a function of the total amount invested. The more you invest, the less likely that you will be able to find enough loans that meet your loan filtering criteria month-to-month. At that point, you have to make the decision to either expand your criteria or increase the amount you invest per loan. Right now, I am still able to find enough loans that meet my criteria. I do not expect that to continue forever though.
TL;DR Minimize for as long as possible but not in expense of your criteria

Dale P
Nov. 27, 2013 2:01 pm

Great tips and great comments.

I recently signed up with Prosper and Lending Club and so far I think lending club offers a better user experience. I am a little concerned that they may be losing touch with customers once the big money comes in…it’s already happening.

Diversification is definitely important with any investing you do.

I initially started off investing in A grade loans but I’m learning to diversify there as well. I’m focusing less on the grade of the loan and looking more at the profile of the borrower.

I hope to find more crowdfunding sites other than lending club and prosper which will allow me to diversify even more.

The peer to business and peer to real estate seem interesting but they are not available to regular investors…accredited only 🙁

Joe B
Joe B
May. 7, 2014 10:23 am

To Quote, “so with a fully invested $10,000 account, for example, you can see new cash coming in at the rate of $400-$500 per month”.

I don’t see how that is possible. Can someone explain? The average note at say 15% will yield about 60 cents a month. 60 cents times 400 notes will equal about $250 a month in cash flow. Where and more importantly how does the author come up with $400-$500?

CT
CT
Oct. 29, 2014 4:16 am

@Bilgefisher & everyone commenting on diversification. I think you could take a look at studies done with stocks and stock mutual funds. They talk about the risk of OVER-Diversification. I think if you have a very small amount to invest then going the $25/loan makes sense. For myself… if I see a loan that “I like” (good interest rate and ability to pay looks very solid) then I want to invest more in this loan. If a loan looks more risky (high interest rate but ability pay a bit sketchy) then I want to risk less and go with the $25 investment. So I think each person needs to judge what diversification is “right” for them and not simply think – I am making $25 investments therefore I am diversified. The other area of diversification is across all risk ratings… if you are only investing in E and HR loans you are not diversified. If you invest only in AA loans you are not diversified. You may have a high probably of a return but the risk is that your return is going to be much smaller than you could achieve by extending to other risk rated loans. By comparison – today there are almost 8000 mutual funds. If you chose to invest an equal amount in all 8000 you would surely underperform and single investment in the S&P500 or Total Stock Market Index. So be aware OVER-diversification is also risky… I like the advice of Bilgefisher => “Spend your time honing in on the right type of notes.”

Dave
Dave
Nov. 10, 2015 2:01 pm
Reply to  CT

I too think the over diversification risk does not work here. Also, when thinking about diversification (risk control) you have to also factor in your desired return. If your financial position allows you to be content with achieving market or average returns for a given investment class, proper diversification is the way to achieve it. If, on the other hand you need to outperform the market, you will need to correctly choose the sectors that will outperform the market for your given time horizon. The greater your percentage need and time horizon to outperform the market, the more likely you will fail.

This point is proven every year by professional money managers the majority of which cannot even match (much less exceed) the market indexes over time. The vast majority of individual investors would achieve better returns with index funds than any other investment strategy.

As to Lending Club most would be wise to invest across the risk grades and in appropriate dollar amounts to avoid heavy exposure in any one risk grade. The real test here will be how LC investments will do in a recession, particularly a severe and or long lasting one.