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P2P Lending is Not Like Picking Shares
Back on Wednesday, 30th July 2014, there was an interesting interview on Money Box on BBC Radio 4. But I only just listened to it this morning.
At roughly 13 minutes in, the conversation turns to one man's experiences with peer-to-peer lending.
That man is John Spiers, He is a founder of Bestinvest, which does investment management, investment advice, and other services that promote or recommend traditional investments.
P2P lending is not exactly like picking shares or funds
John undoubtedly knows a great deal about picking shares.
Speaking as an investor with nearly 20 years experience myself, I think there's an awful lot that individual lenders can learn from quality share-picking strategies, but, one thing's for sure, they're not identical.
John is probably experienced and learned enough to have a highly concentrated portfolio of just 20 shares or share funds and still be confident that he can control the risks.
But this didn't work so well for him when he spent a lot of time choosing 20 specific borrowers to lend to on Funding Circle.
He wanted to start small to “see how it goes”. But, after fees, bad debts and taxes, he made a loss.
Don't be frightened of the “s” word
But a good lending strategy is not just about understanding your borrowers.
And it's more than getting a high enough interest rate for the risks involved.
A good lending strategy is largely about statistics.
Don't be intimidated by that word. I'm not going to make this complicated, because it isn't.
Just as with share investing, you don't need to understand a load of complicated maths to be confident of getting satisfactory rewards.
If you read investment news and tips regularly you've probably realised by now that the more clever and complicated you try to make your strategy, the more likely you are to be misled by your mathematical accuracy, lose sight of the wood for the trees, and make a massive mistake.
You need lots of loans
So all you absolutely need to know about statistics for P2P lending is that you need lots of loans to make it work.
Because, if, say, one loan out of every 20 goes bad – on average – and you lend in just one loan, you might pick one of the bad ones. (That's a hypothetical example, not the bad-debt rate from Funding Circle.)
In fact, you'd have a much higher chance of picking that one bad loan than rolling two sixes.
You've started small to “see how it goes” and now you've lost all your money.
So peer-to-peer lending must be a bad investment, right?
If you lend in 20 loans, you might still do worse than average and have, say, two loans go bad. Sticking with our hypothetical example, that means there's a one in 400 chance of that happening, so one out of every 400 people can expect it. That's about three times more likely than rolling four sixes. That could have been John Spiers.
Those two bad loans could easily give you at least a temporary loss across your whole portfolio of loans.
But if instead you both focus on low-risk loans and you take a few months to spread your money equally between 100 loans, and lend until the borrowers have all repaid, now we're talking statistics!
The risk of losing money at a website like Funding Circle now falls dramatically.
One other thing you need to know about statistics is that the riskier your lending, the more loans you need to spread out the risk. It could be prudent to lend to 200 or more borrowers if you move up the risk scale.
For really high-risk lending, it doesn't matter how many loans you lend in, you might never be able to get the risk of loss down to acceptable levels.
Start small, but give it a real chance
By all means start small to “see how it goes” if you want to check out whether an investment is a complete scam and the scammers are just going to fly off to Jamaica with your money.
Some cautious individuals doing peer-to-peer lending test the waters for that reason. They do this by depositing a small sum of money the first time, and then withdrawing it immediately.
But you won't give any P2P lending company a fair chance, and do a proper test, unless you do two things:
- Spread your money across a great many loans. As you receive loan repayments and re-lend them then you will spread your money out more widely over time.
- Accept that if you have started exactly prior to serious economic difficulties then it won't be surprising if your rewards are disappointing for now. But that doesn't mean it's not a good investment if you stick with it for five years for the safest P2P lending companies, or for the longer term for other P2P lending companies.
Finally, if you don't feel confident enough to stick with an investment that has started badly after a few months, I don't think you should have invested in it in the first place.
Only invest in something when you feel very confident about the outcome and understand the timeframes involved to give your investments a good chance.
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