I Think Peer-to-Peer Lending Should Be Less Than 10% Of Your Wealth
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Cliff is an experienced freelance journalist hired in as 4thWay's “Chief P2P Cynic” to give you the alternative view. Read about Cliff.
Some months ago, I was chatting with Neil Faulkner, founder and owner of 4thWay. During our conversation, Neil asked me a key question, which I hope to answer today.
Neil's big question: “How much of your wealth would you lend?”
When Neil asked me this question, I promptly replied, “Ideally 5%, and no more than 10%, of a typical UK investor's total wealth should be lent out via peer-to-peer (P2P) lending websites.”
I could tell that my reply shocked Neil, because he responded with, “Really? Why do you say that? Some visitors to 4thWay are comfortable lending out up to half (50%) of their money via P2P lending websites.”
I'll now try to explain why I believe P2P lending should only ever be a minority (and never a majority) of your liquid wealth. Here we go:
1. Unlike cash, P2P lending is not protected by the FSCS
My first and most important point is that P2P lending involves taking risks, since you are investing in loans and therefore not saving. Ultimately, this means that you might get back less money than you put in.
However, the Financial Services Compensation Scheme (FSCS) – a government-backed safety-net – protects 100% of the first £85,000 of cash in bank or savings accounts per person per UK institution. (The limit is sometimes shared across several brands in the same banking group.) Thus, as your money out on loan in P2P lending is not covered by the FSCS, the money you lend out can never be considered to be 100% safe.
That said, it's worth noting that the long-term value of cash deposits (and other investments) is inevitably eroded by inflation (the rising cost of living). Likewise, history lists examples of foreign governments directly confiscating their citizens' savings, but that is a trivial risk to worry about here in the UK.
In short, P2P lending is in no way comparable with saving. At all times, bear in mind that you are risking your wealth in return for higher interest rates than those earned in savings accounts.
2. An introduction to asset allocation
Asset allocation may sound complicated, but is easily grasped. It's simply the process of dividing up your wealth between different assets (things you can own).
For UK investors, these assets typically include company shares (also known as equities), bonds (government and company debts that pay fixed rates of income), property (your home and buy-to-let properties), cash and, more recently, P2P lending.
How you choose to diversify (spread around) your wealth between these assets is entirely up to you. That said, as the old saying goes, “Never put all of your eggs in one basket”. In other words, the more you diversify and the more different assets you own, the less wealth you stand to lose during turbulent times.
Conversely, the more concentrated your portfolio is and the fewer different assets you hold, the more risk you take on (all other things being equal). With a highly concentrated portfolio, there is a greater likelihood that your returns will be volatile (relatively more unstable and inconsistent).
In other words, sensible asset allocation involves reducing your risk by spreading your money around, which is why I do not believe that putting half (50%) of your liquid wealth into P2P lending is wise in any circumstances whatsoever.
3. P2P lending is a tiny market
The total net wealth of UK residents (including domestic property and subtracting debts) was estimated to be around £8.8 trillion at the end of 2015, according to the Office for National Statistics. However, total UK P2P lending since its inception in 2005 to the end of March 2017 totalled £8.5 billion, according to the P2P Finance Association.
Thus, total historic P2P lending to date is roughly one-thousandth of total UK personal wealth. What this means is that the P2P lending market is minuscule compared to cash savings (over £700 billion) and other investment markets.
It's simply impossible for any meaningful number of investors to put 50% of their spare cash into P2P lending, because this possibility is strictly limited by market size and growth.
In my view, this extreme lack of market depth and breadth makes it unwise for lenders to put more than, say, 10% of their wealth into P2P lending.
4. P2P lending lacks public exchanges and large-scale liquidity
The London Stock Exchange (LSE) is the world's third-largest stock exchange, where shares are bought and sold in their billions. Last month alone, nearly 20.4 million trades worth £103.4 billion took place. This high volume of trading means the LSE is one of the deepest and most liquid stock markets in the world, making it easy in normal market conditions to buy and sell shares in UK-listed companies at reasonable scale.
On the other hand, there are no well-established public exchanges or trading venues through which P2P lenders can buy and sell loans. The only way to trade P2P loans is via the platform that originally listed them, making them, in my opinion, highly illiquid assets.
It is this fundamental lack of liquidity that's makes P2P lending unsuited to concentrated investing – and history shows us that low liquidity can disappear completely during abnormal market conditions.
5. P2P lending has existed for only 12 years
Stock markets and bond trading have both been around for centuries (the Dutch stock market is 415 years old), making shares and bonds tried and tested assets. In contrast, the first P2P platform, Zopa, opened for business in March 2005. Hence, P2P lending has existed for only 12.5 years, making it a mere baby in investment terms.
With such a short lifespan, P2P lending returns to date cannot be relied on or extrapolated into the future, making predictions about P2P lending's future performance and returns highly speculative and unreliable.
6. P2P lending is untested in a major downturn
There has been a major recession (economic downturn) in the UK in every decade since the seventies, with one notable exception: the period since 2010 onwards. With 2.5 years of this decade remaining, there is plenty of time for our economy to shrink over six months or more.
Capitalist societies tend to go through boom-bust cycles and the UK is no exception. At present, indications are that we are in the late stages of this cycle. Indeed, Credit Suisse warned in July that the UK is “flirting with recession” and its model predicts that there is a “38% chance of a recession within six months.”
In short, there's a rising probability that the UK economy will undergo a painful downturn at some point, typically accompanied by a contraction in credit and rising losses on personal and corporate lending. When (and not if) this happens, returns from P2P lending will be subdued and could even turn negative for a while.
In addition, we have no idea how P2P lending sites will fare in the next slump, because Zopa was the only site of any real size during the Great Recession of 2008/09. For these reasons, it would be most unwise to extrapolate the limited returns from P2P lending from 2005-2017 into the future.
7. In the long run, shares have produced the best returns
Between 1900 and 2016, the Credit Suisse Global Investment Returns Yearbook shows that equities have produced a ‘real' average yearly return (that means after subtracting inflation) of 5.1%, before investing costs.
In contrast, cash generated 0.8% a year and bonds 1.8% a year. What this shows is that investing in the shares of businesses, as opposed to cash and bonds, tends to produce superior returns over the long term.
Since P2P loans are similar to bonds in a number of key aspects, I think they will likely produce similar returns in the long run, making shares the better bet over an investment lifetime.
To sum up, one of the most important things in investing is to ensure “the return of your capital and not the return on it.” P2P lending involves taking on lending risks similar to those shouldered by banks – and the risk of capital loss is not one to be taken lightly.
For this and the other reasons outlined above, I would caution all investors against putting more than a tenth (10%) of their personal wealth into P2P lending.
Now please tell me what you think in the comments box below!