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What Percentage of Your Investments Should be in P2P Lending?

by Peter Renton on July 20, 2011

Even though I am very passionate about peer to peer lending I never recommend people invest all their money with Prosper or Lending Club. Peer to peer lending should be part of an overall investment strategy that covers a range of asset classes.

What is an Asset Class?

Before I go any further we need to have a basic understanding of asset classes. An asset class is like an investment category – for example the equities that make up the stock market are an asset class. Bonds are another asset class. Cash and cash equivalents (CD’s, money market funds, savings accounts, etc) are another. You could consider real estate another as well as commodities such as gold and oil.

Where Does Peer to Peer Lending Fit?

Peer to peer lending doesn’t fit easily into any asset class – it would be what many investment advisors call an “alternative investment”. It is thrown in with more exotic investments such as futures, currencies, private equity and venture capital. Many of these investments are very high risk, often require a large minimum investment and are subject to wild fluctuations in value. These are not true of peer to peer lending but this is where most people lump it.

Anyway, let’s get back to the original question here. Now, keep in mind I am not a qualified investment advisor, rather I am a self-taught investor with some strong opinions on the subject.

I am not going to get into a discussion here about what percentages of stocks versus bonds an investor should hold. I believe most investors should hold both and in what percentages is a judgment call. Every investor should also have an emergency cash fund in a money market or savings account that you can draw upon for unforeseen expenses.

No More Than 10% of Your Total Liquid Investments

I recommend all investors have no more than 10% of their total liquid investments in p2p lending. Also before they invest a penny they should make sure they understand how investing in Lending Club and Prosper works and the risks involved. The biggest risk is a lack of diversification, this is the one thing that can have a big negative impact on an investment.

Personally, I subscribe to this philosophy. Even though I truly believe in the future of p2p lending, with a mortgage and a family to support I don’t want to be more aggressive than this 10% number. If was young and single I might be tempted to invest 20% or possibly even more but a young person has time on their side.

Why Not More?

Peer to peer lending is not without risks. Just read through the prospectus of Lending Club and Prosper and you will see the risks described in great detail. Putting aside the risk of losing your money to defaulting borrowers there are other risks. This is still a young industry and there is always the possibility that it could be legislated out of existence (not likely but possible).

Five years ago no one would have thought Fortune 500 giants like General Motors or Washington Mutual would go bankrupt. But it happened. Now, both Prosper and Lending Club have contingency plans in place to protect investors should that happen to one of them, but the reality is we don’t know if these plans will work perfectly or not. So there is risk.

Having said that I think the rewards far outweigh the risks but not so much that I would want to put my entire nest egg in p2p lending. I will stick with my 10% maximum and recommend it to others as well. But I am willing to concede that it is a personal preference and others may feel differently.

What do you think? Is 10% not enough or too much? I am interested to hear your comments.

 

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{ 21 comments… read them below or add one }

Jim July 20, 2011 at 11:31 am

I think it would be hard to put a % on what to invest. As an example I have a retirement portfolio of several million dollars. I invest with Lending Club, but would not feel comfortable with several hundred thousand dollars tied up. I have a wide range of investments. I think each person has to decide how much their willing to invest in each vehicle used for investments. Lending Club is just one I choose to play around with a relatively small amount of money. Of course this is just my opinion.

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CA-Lender July 20, 2011 at 12:08 pm

Peter,

Excellent article. Almost as though you read my mind, as I was going to email you and ask your opinion on putting 33% of my liquid assets (10% of total assets, including real estate) in Prosper. I’m 43, and I think 10% might be a bit on the low side, but reading your article, I know that 33% is definitely too much.

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Bilgefisher July 20, 2011 at 2:34 pm

Peter,

10% probably works fantastic nicely for you. Others should look at their end goal, time frame to reach that goal, and risk tolerance. That will determine how much they should invest in high risk investments.

I’m not above 10%, but I would have no issue doing so based on my objectives.

Btw, I don’t disagree with your article. For most people, playing it safe is a much smarter way to go. 10% is a good rule of thumb. For the more proactive investors, they already have a good idea where they need to be.

Jason

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Michael July 20, 2011 at 3:01 pm

@Jim.

I thought about the liquidity issue a lot. This is the conclusion I came to:

How liquid is a stock portfolio is that down 50%? Sure you can sell it… Expect your diet to consist mostly of bourbon for the rest of your life.

Say the same drop that happened in 2008 happened next year, would you rather be in stocks or Lending Club in terms of having to get your cash? You can liquidate in a matter of days for 1% on Foliofn (I think the 1% is crazy high by the way and hope it comes down in the future. 1% is just an insane spread).

I guess what I am saying is for me capital preservation key component in liquidity. If I was going to take a huge hit I would consider the stock market illiquid.

@Peter
I’ve seen the number 10% used by others too. I think it makes sense given the limited history we have of notes. I personally will hover around 10%.

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Peter Renton July 20, 2011 at 3:22 pm

Thanks for the comments everyone.

@Jim, For people with very large portfolios the 10% number might be a little high. But again it depends on your risk tolerance. There are several high net worth individuals with seven figures investments in Lending Club and Prosper (of course that may be a tiny or large percentage of their total liquid assets – we don’t know). As the track record gets longer and their finances improve I could see many more people putting very large sums of money into p2p lending.

@CA-Lender, I am tempted to put more money in as well, particularly when I am getting such great returns. And I will be slowly adding to my accounts but 33% seems like a bit much to me, at least for now. Be interested to hear what you decide.

@Bilgefisher, Far be it for me to discourage investing in p2p lending, I am only recommending people err on the side of caution. But if you have read the prospectus fully and understand all the risks and are comfortable with a higher percentage then I say go for it. We all have a different tolerance for risk.

@Michael, Your stock market analogy is an interesting one. The equivalent of a huge drop in the marker could also occur on Foliofn. If, for example, there is some bad news for whatever reason at Prosper or Lending Club there may well end up being far more sellers than buyers of notes. In which case you may have to price notes at a significant discount just to offload them. But with normal operations the liquidity of notes is really a non-issue. You can sell an entire portfolio of notes in just a few days if needed.

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Michael July 20, 2011 at 3:45 pm

@Peter
I actually feel the stock market crash would have little impact, it might even drive it up (demand on folio). People like to move into fixed income when the equity markets get spooked. The real threat is interest rates.

If the fed raises rates from whatever they are now, 0.0000001% we could see a point in the future where MMAs are offering 4% again which is about as “safe” as you can get. Grade A (~5.5% return) notes will have a hard time trying compete with something as simple as a MMA. LC will have to raise A grade loans to something like 6%. That is where your biggest discounts will happen. Interest rates can only go up from here!

Of course a run on notes is a possibility. If LC tomorrow filed for bankruptcy (unlikely due to the fact they are positive cash now) there would be a rush to the secondary markets with basically no one to buy. Your notes would end up in court.

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Peter Renton July 20, 2011 at 3:58 pm

@Michael, I would agree that the real threat is interest rates. Both Lending Club and Prosper have come of age during the lowest interest rate environment on record. I see Grade A notes going up in a normal interest rate environment. In fact, what I expect would happen is that the volume of A notes would go down dramatically because either rates would have to go higher or there would be no one to fund them. It will interesting to see what happens but in the meantime both companies are certainly making hay while the sun shines.

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Michael July 20, 2011 at 4:28 pm

To put it in perspective:

With a loan for $100K at 5% over 30 years you will pay $193,255 total in debt repayment.

If I invest $100K a mutual fund, it needs to earn 2.2% a year to be $193,255 in 30 years. So in essence the banks rate of return on your mortgage is 2.2% before inflation at this point in time.

Inflation is 3-4% historically on average per year which means every mortgage made in the last 3 years is a loss for the bank over the life of the loan. You get get a 15 year fixed right now for 3.5%. All the banks are doing is making money on fees at this point. Interest rates need to come up, and a lot!

The biggest ally the p2p industry has now and for the foreseeable future is the credit card industry. It’s really not hard to compete with 20+% finance charges. As long as they (p2p) can provide rates lower than them (cc), they will always have business. All you need is the government to say credit card rates can’t exceed 10% then you will really see a notes on folio. :)

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Brian B July 20, 2011 at 7:35 pm

It should be noted that anyone that purchases notes in excess of 10% of their networth is in violation of Lending Club’s Investor Agreement. That was one of those checkboxes you had to check and say you read and agreed to when you created your account. So if you do want to invest more than this in p2p lending, you will need to spread the amounts over multiple sites (or possibly invest only only Prosper, I’m not sure what their financial suitability requirements are).

They probably would never find out if you go over this amount. And even if they did, they might not do anything. But you’d certainly risk having them close your account or take other actions, so its something to at least be aware of.

Exact Text:
“regardless of your state of residence, you agree that you will not purchase Notes in an amount in excess of 10% of your net worth, determined exclusive of the value of your home, home furnishings and automobile.”
https://www.lendingclub.com/info/lender-agreement.action

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Peter Renton July 21, 2011 at 5:50 am

@Michael, I think you are spot on that from the borrower side, as long as credit card companies keep charging high rates there will always be borrowers coming to p2p lending. But from the investor side high interest rates will certainly have an impact. If I can get a 5% FDIC insured return it is going to make me very hesitant to invest in a 7% loan with p2p lending. This is where I see investor money drying up in a high interest rate environment. There will be little demand for the low risk notes and so the risk equation may become skewed to more high risk notes.

@Brian, Good catch. I missed that one. I am glad I decided that 10% was the most an investor should have in p2p lending. Of course, this kind of thing would be very difficult, if not impossible, for Lending Club to police so I doubt they would take action against any individual investor. I think it is primarily there for the legal department. If someone invests 50% of their liquid assets, loses it all and then sues Lending Club for the loss, they can say that, sorry but you were in violation of our investor agreement.

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ChasingBread July 21, 2011 at 11:19 am

Scared money doesn’t make money (jk but the saying is a bit funny and true) .

Invest what you can afford to lose into P2P. I have invested solely into Prosper and made $20k in interest in a year. Of course, I have not recouped my initial investment but things are looking good. This month will be 15 months of enjoying the risk of P2P.

10% is a very good number for people with more financial responsibilities than me. I have 0 debt; therefore, I can afford to play big like this.

CA-Lender, I say go for it if you have the money to risk. Peter gives great advice on here. Diversify, but not to the point where you don’t have time to study each and every loan you invest in. Thats my motto. I can low enough where I have time to study each and every loan I invest in. I do not use quick invest nor did I use the automated plans.

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Peter Renton July 21, 2011 at 5:10 pm

@ChasingBread, Good points. While I think it is unlikely you will lose your money with p2p lending if you are an educated investor, it is a good rule of thing to only invest what you can afford to lose. The only thing I would disagree with you on is the necessity of studying every loan you invest in. That is a personal choice, but I don’t consider it to be essential for success in p2p lending.

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Charlie H July 21, 2011 at 6:51 pm

“10% of Your Total Liquid Investments”

The only truely Liquid Investments is cash and short duration T-bills. Sure you can liquidate a mutal or bund fund at any time, but the question is at what price.

You can liquidate your house tomorrow if you wanted to sell it for 50% bellow par. Is a home a liquid assest?

IMHO Lending Club should be looked at as the JUNK bond / high yield portion of your bond portfolio. It has the same interest rate risks after all.

If you are 70% equities, 20% bonds and 10% cash then lending club should be a portion of the 20% part of the bond fund.
The 10% cash is there so you do not have to sell durring pull backs if you need extra liqudity.

With that in mind the 10% limit LC places on total net worth is more then adaquate.

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ChasingBread July 21, 2011 at 9:09 pm

@Peter, you are absolutely right. I should have expressed that better; it is a personal choice. I diversify a bit but not as much as others. I like to diversify to the point where I have enough time to look at each one and ask questions if i have any.

Depending on the loan you may not have enough time to ask questions. Worth-blanket2 has been funding good loans completely or at least most of it on Prosper.

He is leaving the little guys like us out but on a flip note, if you do get some money in at least it will process quicker and become a note faster.

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Peter Renton July 22, 2011 at 6:41 am

@Charlie, Even though there is no underlying price movement, I agree the closest asset class to p2p lending is high yield bonds. Although consumer credit is really the asset class where it fits most nicely this is not considered an asset class for the retail investor. While it is true most assets can be liquidated it is generally accepted that liquid assets only include those assets that can be liquidated quickly and easily.

@ChasingBread, This is the one problem with the new QuickInvest feature on Prosper. With big players like worth-blanket2 you can miss out on loans that meet your criteria because they are snapped up in hours by these large investors.

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Bilgefisher July 22, 2011 at 7:27 am

All valid points here. 10% is net worth. I’m only playing with liquid investing reserves. Much of my net worth is far from liquid. That’s were my risk tolerance hits its boundary.

Peter, you mentioned you have a system yo look through many notes and invest in under 15 minutes. I think any one who doesn’t do that is wasting their time. I will admit though, I spend more time playing with numbers on lendstats, then looking at listings.

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Charlie H July 22, 2011 at 8:52 am

@Bilgefisher
“Much of my net worth is far from liquid” I know that is true for me. My 401k and home make up a about 2/3 of my net worth. Neither are liquid. The remaining portion is in cash in the form of an emergency fund, a broker account, and Lendingclub.

The Lendingclub account makes up ~5% of my total net worth, but is 18% ex-home and ex-401k. I’m thinking 20% is pretty much my near term top end.

Lendingstats is a great tool. It an open source data mining tool that is powerful. I’ve found some of my “common sense” filters didn’t perform any better then average and have adjusted them based on using Lendingstats.

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Bilgefisher July 22, 2011 at 12:56 pm

My whole lending criteria changed after studying lendstats data for many hours.

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Peter Renton July 22, 2011 at 2:22 pm

@Bilgefisher, You know I am working on a new system right now (basically some Excel automation) that will take my investing time down from 15 minutes per week to around 1-2 minutes. I know there are plenty of people who like to take their time and study each loan carefully, but I am not one of them.

@Charlie, Even though a 401k isn’t (or at least shouldn’t be) exactly liquid I think you will find that Lending Club would include that in your total liquid assets. Anyway, it sounds like you have settled on a level of investment that is right for you. I want to echo @Bilgefisher’s remarks – what I discovered Lendstats it completely changed how I chose notes for investment. Filters that make “common sense” as you say can underperform those that don’t make any sense at all. But I let the numbers decide the strategy for me.

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Moe July 30, 2011 at 1:36 pm

@Peter, I just saw this on Lending Club: Regardless of your state of residence, you may not purchase notes in an amount in excess of 10% of your net worth (exclusive of the value of your home, home furnishings and automobile). http://www.lendingclub.com/kb/index.php&View=entry&EntryID=113
Prosper on the other hand lists this limit only for Idaho, New Hampshire, Oregon, Virginia California and Washington. I’m pretty sure, Lending Club has it wrong on this, an only in certain states this limit applies.

Lending Club also writes: Investors who are residents of states other than California or Kentucky must have (a) an annual gross income of at least $70,000 and a net worth (exclusive of home, home furnishings and automobile) of at least $70,000; or (b) have a net worth of at least $250,000 (determined with the same exclusions). In this as well, Prosper lists the limit only for these few states.

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Peter Renton July 30, 2011 at 7:47 pm

@Moe, Thanks for the clarification and the link. It is interesting that Prosper uses different rules than Lending Club and some states obviously have different requirements. Anyway, it just confirms that my 10% suggestion is a number that all investors should adhere to.

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