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3 Steps to Fit Peer Lending Into a Diversified Portfolio

Peer lending investing offers a unique investment opportunity that can potentially change the investing landscape for investors.

Whereas in the past, only banks had the opportunity to lend money to individuals as personal loans, now anyone with the money to do so can participate. Through websites such as Lending Club and Avant, investors can find borrowers looking for such a loan, whether for personal or business needs. Even borrowers with poor credit can access funds through these online marketplaces, and investors are generally compensated with higher interest rates in return for the greater risk.

With relatively strong returns compared to other fixed income products, such as CDs, government bonds, and even most corporate debt, investors might wonder why they shouldn’t just invest all of their investment capital in peer-to-peer loans.

Why not just stick with what works?

However, when deciding an overall asset allocation for your retirement portfolio, you want to consider not just the weighting for a particular asset class, but also the way it is likely to interact with the other pieces of your investment puzzle. You obviously want to avoid having all parts of your portfolio suffer losses together in bad economic environments. These are important considerations before deciding on the role peer lending will play.

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Step One: Consider Your Peer Lending Time Horizon

Since peer-to-peer loans typically range in term between three to five years, you obviously don’t have access to your investment capital during that time frame. In comparison to other investment assets, that’s an intermediate time horizon.

If we look at money markets or savings accounts, for example, you can generally withdraw money without penalty at any time. (There may be a limit on the number of withdrawals per month, but generally speaking there are few restrictions.) CDs, or Certificates of Deposit, often pay slightly higher interest rates than money markets, but also lock up your money for a longer term. While they do allow savers to withdraw the funds early, there is often a small penalty for doing so.

Generally speaking, bonds (or bond mutual funds) are more conservative investments than stocks, but more risky than bank savings accounts, such as money markets and CDs. They should not generally go down as much as stocks in a bear market (unless we are talking about “junk” bonds), but they certainly can and do fluctuate in value as market conditions change.

Further, if you hold a long-term bond (or bond fund), you should know that these can be very sensitive to changes in interest rates. So even in a rising stock market environment, long-term bonds can go down in value when interest rates rise, sometimes even double-digit amounts. But for the most part, bonds are generally considered to be more appropriate for those with short-to-intermediate time horizons.

For stocks, in theory you can convert them to cash immediately by selling them in your brokerage account. However, in reality stocks are aggressive investments that can go down in value, sometimes in extreme amounts.

While any individual stock can go bankrupt and thus become worthless, a broad basket of stocks (in a mutual fund or ETF, for example) should not lose 100% of its value. However, as the Great Recession of 2008-2009 taught us, even a diversified portfolio of stocks can lose tremendous amounts.

For example, the S&P 500 was down about 54% from October 2007 to March 2009, and didn’t fully recover from this drop for another four years. For this reason, in my opinion it is generally advisable to have a long-term time horizon (10+ years) when investing in stocks, but for those who do, you are generally rewarded with higher returns than bonds in most historical periods.

Step Two: Consider Your Overall Appetite for Risk in Peer Loan Investing

The famous economist, Milton Friedman, taught us long ago that “there’s no such thing as a free lunch.” What this means when it comes to investing is that in order to get returns over the long term, you have to be willing to take some risk. The two go hand in hand.

In fact, historical data shows that there is a relationship between risk and return over time. The more aggressive your portfolio is, the more potential return it can make, but also the more risk it will likely experience.

The same thing is true for peer lending investors. The loans that pay the most in interest are likely to be riskier when compared to lower-paying loans. The important take-away from this is to look at your portfolio as a whole, and make a decision as to how much risk you are willing to take.

Successful investing in peer loans means picking the loan criteria that produce higher returns and lower defaults. I recently shared my favorite loan screens for peer lending investing and how I make 12% annual returns.

Step Three: Remember that P2P Investment Diversification Reduces Risk

Carl Richards writes in his brilliant book “The Behavior Gap” that “being slow and steady means you’re willing to exchange the opportunity of making a killing for the assurance of never getting killed.” While each loan you pick is carefully researched, it is still always a possibility that the borrower will never pay you back. In this way, peer to peer lending is the same as an investment in an individual stock or bond.

In all investing, there are always risks facing an individual security, and that’s why diversification is so important.

But there’s more than just having a certain number of investments to diversify the risk. You also want to consider how certain economic phenomena might affect all the investments together for the worse. For example, back before the Great Recession, the U.S. housing market was driving a larger and larger portion of the economy. Not only were banks and home builders doing well, but the economy as a whole was riding on the crest of the real estate bubble.

In the same way, you may want to consider balancing out the portfolio with investments that do well in various economic scenarios, since none of us know the future.

Making P2P Investing a Part of Your Portfolio

The first rule of investing is to get return of capital, before worrying about return on capital. While peer-to-peer lending is a new, unique, and exciting investment strategy to appear on the investor’s radar, it is important to understand where it fits into an overall investment allocation to add flexibility, safety, and consistency to a portfolio over time. Used intelligently, peer-to-peer lending can add increased returns and additional diversification to your portfolio.

I want to thank Curtis Hearn, CFP for this post on how to make p2p investing a part of your investment portfolio. Peer lending investing is quickly becoming one of the best asset classes for investors, providing stronger returns than bonds but safety from stock market crashes.

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