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I Know What You’re Thinking About P2P Lending And You Were Right All Along

Taking a hard, cold look at that jumble of ideas, desires and fears we have in our own noggins should not be an afterthought, and reading about investor psychology not just something to do one idle evening in an armchair after we've already got our money invested.

Instead, I think it is the most important aspect of investing.

It doesn't take a huge amount of effort to learn enough about peer-to-peer lending, shares or any other quality investment to get started safely, provided you focus on the simple strategies.

But to prepare and protect yourself from irrational investing requires a deep understanding of how things go wrong upstairs. And you need solid ideas to prevent that happening.

Indeed, I believe you need more psychology books on your shelf than books on money and investing, because this is where all the big mistakes are made.

The three biggest mistakes investors make, in my opinion, are in their heads. Here they are, as well as how you can defeat them.

I'm right. Period!

My title to this article was inspired by Padraig O'Hannelly, a former investment journalist, now chief editor of Iraq Business News. He wrote an article for The Motley Fool with the title “You're Completely Right!”

He was playing on the fact that we are much more likely to pay attention to someone if they agree with us. We look for evidence to prove what we believe already, dismiss any arguments to the contrary. That's what we all do and it's a problem called confirmation bias.

Why else do you think we all believe we're right 90% of the time in an argument? Unless we only ever pick fights with people a lot more stupid than us, even the cleverest among us should still expect to be right closer to 50% of the time.

In investing – including peer-to-peer lending – confirmation bias leads to bad investment choices.

For example, you have a preconceived view that peer-to-peer lending website is too risky, and look solely for evidence to back up that viewpoint.

Or you feel that a particular P2P lending site is wonderful and so brush aside the mountains of evidence warning you to stay away while you dig around for the crumbs of good news that will confirm what you really want.

How to beat confirmation bias

There is a simple trick that I have used for a long time that I have found very effective in combating confirmation bias. I think it is one of the main reasons why no one has called me “stubborn” for many years.

In short, the technique to beat confirmation bias is to try to destroy your best loved ideas.

In peer-to-peer lending, that works like this:

  1. Think about whether you currently are feeling positive or negative about P2P lending (or an individual P2P lending site, lending account, IFISA or even loan – depending on what precisely you are looking into) and then
  2. Try and prove the opposite to be true.

If you can't prove the opposite, you can go right ahead with what you wanted to do in the first place, with a more thorough understanding of what you're doing and even greater confidence.

If you can prove the opposite, you've become wiser and achieved a rare thing: you've change a favoured idea or viewpoint of yours.

It might seem like a headache to you, but once you get used to it you might even find you enjoy it, in a masochistic kind of way. And it is less traumatic than rushing into an investment and regretting heavy losses later.

Jump on the bandwagon – it's rolling!

The “bandwagon effect” is when you stop thinking for yourself and do what a big crowd is doing.

Unfortunately, crowds are not always wise, especially in specialist fields like investing. It is crowds that follow each other, and goad each other, into bubbles and crashes.

At present, peer-to-peer lending is still growing and in a fairly neutral phase.

But there will be times when clear-headed people (especially those who regularly challenge their best loved ideas) can easily see that the risks of lending through one P2P lending site have risen dramatically, or that it has changed so much it is no longer possible to predict the risks.

Yet, I guarantee you, if that P2P lending site has historically been stable and profitable, a large crowd of people will unwaveringly believe it will continue to be a safe bet in the future.

The main factor driving that belief is the large crowd of people who unwaveringly believe it will continue to be a safe bet in the future.

That was not a typo. The crowd gives itself undue confidence, even as the evidence to the contrary stacks up around them. They will not just be misled by the calm reassurances from the P2P lending sites, but also – and indeed mostly – by everyone else in the crowd: “A whole load of other people aren't panicking – yet – so why should I?”

The next sentence is important for investors regardless of what you invest in, so pay attention:

It is always at the point when lots of people are thinking an investment is completely safe and can't go wrong that it bubbles up and bursts.

In other words, investments are least safe when masses of people are saying they are safe as houses.

Why? Well, take a peer-to-peer lending site like RateSetter. Interest rates there are set entirely by the crowd with no minimum interest rates. If lots of lenders pile in because more people think it is safe, not only would this put pressure on RateSetter to approve more borrowers – who might be higher up the risk scale – but also interest rates are pushed down.

It's about supply and demand. If there is loads of lender money flooding in, lenders have to compete with each other to lend. They must bid lower interest rates to get their money lent out to too few borrowers.

At some point, interest rates get too low for the risks, and this peaks at the time when the largest number of lenders feel totally safe – because it coincides with when the most lenders have plunged in.

The next recession after that could see lenders make unexpected losses, because they haven't earned enough interest to pay for the risks.

In RateSetter's case, those losses would be tiny compared to the losses investors make on the stock market during a big downturn, because money lending is inherently a lot less risky than buying shares and RateSetter has the skills and resources.

But it would still be shocking for those lenders who want to maintain positive results and who expected nothing else.

Worse than that, if those lenders then panic, they might bring even larger losses on themselves. When lots of lenders try to sell their loans at once, they might find the only way the P2P lending site could let them out quickly would be to sell their loans to other lenders for less than they are worth.

At times, the tables will turn the other way. Instead of the crowd being euphoric about the future, there are lots of frightened people. Those who made losses at websites where rates were allowed to get too low are now saying “it's been a horrible mistake” lending here.

This is when there will be a lot more borrowers than lenders. Confident lenders who think for themselves instead of following the crowd now have the luxury of charging higher interest rates. This is the most profitable time, and the lowest risk time, to be lending and investing – when  the crowd is still panicking. Those on the panic bandwagon miss all the fun.

How to beat the bandwagon effect

You must diverge from the crowd when they are being euphoric or fearful. To do that, use an extension of the trick I already mentioned:

  1. Be aware of great enthusiasm or extreme fear.
  2. Then look to prove why the crowd is wrong.

However, there is one other vital ingredient in combating the bandwagon effect.

Investors, including those of us doing peer-to-peer lending, need to form our own independent, considered views, like all the best investors do. To do that, you need enough knowledge about what you're lending in and enough confidence about what you're lending in. Otherwise, you will never be able to confidently tune out the crowd when you really need to.

You overconfidence is your weakness

Sorry, I'm sure that sub-heading must have been used on the internet by Star Wars fans thousands of times, but I couldn't resist.

In peer-to-peer lending, overconfidence usually shows itself when people decide to lend in too few loans.

We have seen a beginner investor lend 10% of his money in just one single loan that went bad.

There's some truth in the idea that the less you know the more confident you are that you are right. I've seen that many times in investors over the past two decades.

And yet here's another example of overconfidence: I have seen an experienced investor make a similar mistake to the beginner investor: he lent his money in just 20 unsecured business loans.

He then seemingly panicked and got out for a loss, and then he wrote off the entire peer-to-peer lending industry after that.

Now, that same investor even founded a very popular website to help investors choose share investment funds.

In this case, it looks like the investor incorrectly assumed that his (probably well-founded) confidence in investing in share funds would transpose automatically into another form of investment. It never occurred to him that he had brought that high risk on himself by making the absolute most basic mistake in peer-to-peer lending: not spreading your money across enough loans to hugely reduce the risks.

He probably is a good enough investor to choose 20 investment funds, or maybe even 20 individual stocks, and come out with satisfactory results. But that's a completely different game to lending. In lending, there are no “100 baggers” that will turn £10,000 into £1,000,000. So there's no point taking the obscene risk of concentrating your money that much.

The reality is that no banker in her right mind would dream of lending to a mere 20 people or businesses in unsecured loans. That overconfidence would see them fired.

Finally, consider research from my favourite stock-market researchers, professors Dimson, Marsh and Staunton from the London Business School, who produce the outstanding Credit Suisse Global Investment Returns Yearbooks and Sourcebooks. They have shown that it's the most active investors – who are arguably the most confident in their abilities – who perform the worst on average!

I even know some of these people. They are always pushing to beat the market and they end up doing worse than the person who just buys the same boring investments month in, month out, with no hope or expectation that their investments will quadruple in value overnight.

So even knowledgeable people can get overconfident and take too many chances.

How to beat overconfidence bias

There are three cures for overconfidence: knowledge, vigilance and humility.

You need to learn about what you're doing before you start. And then you need to keep questioning. And you probably need to be comfortable with satisfactory results rather than trying to beat everyone else.

Read more:

All 4thWay's experts are required to try to destroy their best-loved ideas before writing a review of a P2P lending site. Read Quick Expert Reviews on dozens of peer-to-peer lending opportunities in our peer-to-peer lending comparison tables.

Read more on psychological and other risks, and how to reduce them all, in The 13 Key Peer-To-Peer Lending Risks Risks.

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