How One Lender Is Losing Money – A Lesson In P2P Lending Diversification

This guide page is to:

• Describe to you just how incredibly powerful it is to spread your money across lots of high-quality loans.
• Offer guidance on how much diversification you need.
• Give you tips on how to go about doing that and how to lower the risks even further.

How not to do P2P lending

Here's a true story. A lender put £1,000 into Funding Circle, which, at that time, was offering P2P loans to small businesses. He complained to The Guardian that he had so far made £115 interest after costs, but had outstanding bad debts of £128.

The bulk of the bad debt came from a single loan. The lender had put a whopping 10% of his £1,000 into that loan.

Luckily for the lender, the situation is likely to be temporary. Firstly, he will continue to make interest on his good loans for years to come.

Secondly, Funding Circle said it expects to recover enough of the bad debt on his large bad loan within a few months to put him back into profit. Indeed, it is typical for many kinds of lending that some loans go bad early on. That might worry amateur lenders, but, provided the P2P lending site knows what it's doing, recoveries and interest earned over the following months and years is expected to make up for that.

But that's not what you should be learning from this story in The Guardian:

What's important about this story is that you make it far easier to lose money if you just lend in a few loans. Putting 10% of your money in just one loan to a small business borrower is simply too risky and misses the point of money lending.

On the flipside, if you spread across lots of quality loans, it is very difficult to lose money. More on that in a moment.

Let's put it this way: if you had money in an account at a very small bank, and that bank lent 10% of all deposits by its account holders to one borrower, would you be happy with your bank about the risks it was taking?

Of course not. A few bad loans and then a recession, and you might have to face a run on your bank. That could be pretty nerve-wracking for savers.

The same standards apply to ourselves as individual lenders.

The absolutely extraordinary protection you get from spreading your money around

Very loosely speaking indeed: if you lend in an ordinary personal loan to just one single individual borrower, right at the moment a very severe recession kicks off, you might have around a 10% chance of losing 3/4 or more of your money.

It seems to us that not many people want to have a 10% chance of losing most of their money. That sort of risk is not what P2P lending is about.

However, the maths changes completely in our favour when we lend to many borrowers:

That is a lot better. Your stock-market investments during a severe recession have a far, far higher chance of doing worse than those loans. Which is appropriate, since the stock-market is generally higher-risk, higher-reward than money lending.

It gets better

Those odds might still not be good enough for you. Prime borrowers are supposed to be low risk and paying relatively low interest compared to, say, lending to property developers.

You might want to reduce the risk further. And so you double down: lend to 200 of the same quality borrowers instead of 100.

Doing this, the risk of losing more than 13% of your money during a severe recession, before interest, falls to 0.1%. That's a lot better.

We're making some fierce assumptions in calculating all these odds, so the chances of losing that much money are probably even lower. This example is simply an extremely bad scenario for you to work with. After all, investors (including those of us doing P2P lending) should invest with a “large margin of safety”. (See 4thWay's 10 Principles Of Investing.)

Reserve funds are on top of that

Now, on top of those rough odds, you can factor in other things, such as reserve funds to cover expected losses, insurance to cover bad debts when borrowers are made redundant in a recession, and other protections offered by P2P lending sites.

Plus, you do earn interest on the good loans, and on the bad ones before they turn bad. Remember that a loan can only turn bad once, but most of your good loans will earn you some interest for several years.

How many loans do you need to lend in?

The founder of one of the P2P lending company's said that, to him, P2P lending is not about protecting against 1-in-100-year recessions. Yet that's his opinion, because these kinds of extreme events are precisely what 4thWay likes to plan for and it incorporates that into its 4thWay PLUS Ratings and Risk Scores.

Ultimately, it's up to you how much risk you want to take on.

But doing some rough, but tough, sums, based on 4thWay's standards, we can loosely categorise the number of loans lenders need to have a large margin of safety during a severe recession. Here we go:

4thWay Risk Scores are based on a very-tough-bordering-on-mean version of the international “Basel” stress tests that banks are required to do on their own loans, and factor in the type of lending, bad-debt performance, reserve funds and other factors.

The table above goes up to a risk score of 7/10, since that's the limit to risk that we think most lenders would consider appropriate. Higher 4thWay Risk Scores represent risks that we calculate are at stock-market levels, and are therefore probably not suitable for most lenders.

You might be willing to take more risk and that's perfectly acceptable, but you need to decide in advance what's acceptable to you and stick to it, especially during times when other amateurs and experts around you lose their minds. That happens an awful lot in investing.

It's quite simple really: if in doubt, don't get greedy. Stick to your lines in the sand and be proud that you're thinking for yourself instead of being another sheep.

Just to stress that, despite the skills, data and knowledge behind 4thWay, the number of loans that are estimated in that table is not some kind of guarantee, not least because each P2P lending company is different. As 4thWay gets even more data, we hone those estimates further. Also, statistics and what happens in the real world are not always aligned.

5 ways to diversify even further

All the above assumes you just put your money into one P2P lending site just as a severe recession crashes down on you.

However, to diversify, improve your returns and lower your risks an awful lot further, you can use these five additional, solid techniques:

• Drip your money in over many months to spread across more borrowers.
• Re-lend your money consistently, including before and after a recession.
• Select lower-risk borrowers.
• Lend to different types of borrowers through multiple P2P lending accounts.
• Use other types of investments and savings products as well.

Where to get started in spreading your risk

To get started in spreading your money across lots of loans:

• Look for P2P lending sites that offer at least some automatic diversification. You can see which P2P lending sites offer automatic diversification by looking at the “Description” column in our comparison tables.
• Bear in mind that some P2P lending sites will only spread your money around enough when you lend thousands of pounds.

Finally, here's a chart, not based on a real P2P lending site, that shows the kind of spread of results you might expect. It is based on lending to typical unsecured business borrowers. Higher-risk lending would have a wider spread of results. Lower-risk lending a smaller spread, with less chance of negative results.

This was part ten of our ten-page P2P lending guide

Read part nine: The IFISA (P2P ISA) Guide.

See the contents of the whole guide.

See the 4thWay Risk Scores in our comparison tables.