I have to start off by admitting that so far, I’ve been consistently making about 20% on my peer-to-peer lending investments, which is obviously a great return. But I stopped investing more money in Prosper and Lending Club after realizing just how fragile this house of cards could be. Here’s some quick background on the companies, and why I feel it’s time to part ways.
The First Isn’t Always The Best
Prosper and Lending Club connect investors, who each lend as little as $25, with borrowers in order to “crowd-fund” the borrower’s loan. Loans can be for almost anything, including debt consolidation, house remodels, vehicle purchases, and medical expenses. The loans are non-recourse, which means they are not secured or collateralized by any underlying asset—just the borrower’s promise to pay back the loan. To compensate for this risk, the loans carry relatively high interest rates—as much as 30% or more for the riskiest borrowers.
When Prosper and Lending Club were founded, they definitely disrupted the market of traditional investments. All of a sudden, small-scale investors could invest like banks and private equity. We have to give Prosper and Lending Club credit for providing investors with a brand new alternative way to earn attractive returns.
It was also great for borrowers because it allowed them to obtain loans that were previously unavailable. For instance, traditional banks would never make credit card debt consolidation loans without collateral, and although the interest rates are fairly high for risky borrowers, those rates in many cases are considerably less than the near-usurious rates charged by credit card companies.
But now there are lots of second-generation “alternative” companies, like Fundrise and Yieldstreet, that offer even more investment options to investors looking to diversify their standard stocks-and-bonds portfolio. To me, some of the newer crowd-funded investments just make more sense on a risk-adjusted basis than the investments offered by Prosper and Lending Club.
Why Are P2P Loans Risky?
The biggest selling point with P2P loans from Prosper and Lending Club is that you can diversify with incredibly small amounts of money—$25 buys you a piece of a loan, so with only a $2,500 investment, you can lend money on 100 different loans to 100 different borrowers. If one borrower defaults, you’ll barely feel it. This high degree of diversification should mean complete safety for the investor, right?
This is sounding familiar…
Let’s take a stroll down memory lane to the most recent market “crash”—the 2008 housing crisis. Back then, banks were selling a lot of CDOs, or “Collateralized Debt Obligations.” CDOs were investment vehicles that packaged together thousands of individual mortgages. Those packages were then sold off to investors or other banks. CDOs of “sub-prime” (a politically-correct way to say “extremely risky”) mortgages were packaged together, and then sold as a higher grade investment—i.e., one that was considered less risky. It was thought that by lumping together so many mortgages, the risk of any one default became less of a concern because of the “diversified” nature of the entire investment.
Of course, we learned the hard way that this assumption isn’t true. The housing crash was a very complicated market event, but one lesson is pretty easy to grasp—packaging together a bunch of risky investments does not necessarily make the investment as a whole less risky. So then are the benefits of diversification a lie? Of course not. Diversification is vital to reducing portfolio risk, but it only helps if there is some level of negative correlation between each investment.
When Does Diversification Actually Help?
Let’s use Starbucks stock as an example. Even though Starbucks is generally considered a strong and ethical company with good growth prospects, if your entire net worth is in Starbucks stock, you run considerable risk that something could happen to destroy the value of your portfolio. For example, Starbucks could fall out of favor with investors, or the public could generally lose interest in buying coffee as a status symbol (which would leave only us hardcore caffeine addicts to support the company).
If you wanted to reduce your risk, you could sell half of your Starbucks stock and buy stock of another company instead. If you bought Dunkin Donuts, you would insulate yourself from some risks (for example, accounting fraud committed by Starbucks), but you would not insulate yourself from the risk of customers buying less coffee in general. Also, neither company provides a “vital” product or service (the caffeine addicts might disagree), meaning that if the economy slowed, or unemployment rose, people would probably either stop drinking coffee, or make it at home for pennies on the dollar.
Thus, buying Starbucks and Dunkin Donuts provides only limited diversification value. You might be better off, for example, taking half of your Starbucks stock and investing it in a utilities company, as utilities are less discretionary than coffee, and a utilities stock probably will be affected by different market forces.
There is little value to diversification if the risks that make both investments “risky” are the same. The more likely it is that market events affect two investments in the same way, the less “diversified” those investments are.
Do P2P Loans Offer “Good” Diversification?
This brings us back to Prosper and Lending Club. The idea with these investments is that by loaning out on hundreds of different loans (at only $25 per loan), you cut your risk of any one loan defaulting. That’s partially true, but you don’t insulate yourself from a market event that would impact all, or at least a substantial number of the borrowers in your “diversified” portfolio.
No offense to anyone who has taken out a loan on Prosper or Lending Club, but most of the borrowers there are very high-credit-risk individuals. In my current Prosper portfolio of about $4,000 worth of loans, I generally have 4-8 borrowers whose payments are late at any given time (I also invest in the riskier loans, but in my opinion, the lower interest rates on the “safer” loans don’t come close to justifying the risks of a non-recourse loan in the first place).
Clearly these borrowers are financially unstable even when the economy is roaring—I don’t want to find out what happens during a major market event. It’s not hard to imagine another event similar to the housing crash that impacts a wide variety of people, including those who borrow on Prosper and Lending Club. Just look at what happened during 2008—people walked away from their HOUSES! If people are willing to (or have no choice but to) default on their house mortgages en-mass, how do you think they’re going to feel about defaulting on a credit card consolidation loan that is not backed by any collateral? My guess (no, this is actually more than a guess) is that they’ll turn their backs on those loans without a second thought, obliterating most of my 20% returns in the process.
What To Do Instead?
I think there are smarter ways to deploy my investments, and I follow this general framework of priorities:
- Save An Emergency Fund. By keeping six months to a year of basic expenses in liquid savings, you can insulate yourself from many major market events, and even personal events that have financial consequences. This safety net will help you make rational investment decisions, even if your investments hit a rough patch;
- Buy assets before liabilities. This is the name of the game. After saving up your emergency fund, focus on this! I’d rather lend my money out on a risky Prosper loan any day than spend that money on a loan for a car that I don’t need. At least I have some chance of making money with the P2P investment—instead of knowing that I’m paying interest on a loan for a depreciating asset;
- Keep Diversified. When buying assets, maintain your overall target allocation, which should include domestic stocks, international stocks, bonds, and alternatives—all investments that are to some degree negatively correlated with each other. This is how I allocate my investments;
- Pick Good Investments. For the alternatives category (to which Prosper/Lending Club belong), consider investing with Fundrise or Yieldstreet instead. I think the collateralized nature of these investments offers a much greater level of protection that the non-recourse loans offered on Prosper and Lending Club. (Keep in mind that these investments are still very risky, and should likely occupy only a small percentage of your overall portfolio.)
If you invest with Prosper or Lending Club, comment below and let us know how those investments have performed, and whether you think that performance will continue during market swings.