Investing 
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Why I Don’t Invest In Peer-To-Peer Lending

In the blogosphere there seems to be a lot of excitement about peer-to-peer lending which is the ability to lend money to other individuals through companies such as Prosper and Lending Club. While I can understand how some investors will always be interested in a new investment product I don’t really understand the widespread excitement and interest level for this one.

Some of the things people should think about when considering P2P lending:

Diversification

Lending to one person is kind of like investing in a very small risky stock such as a junior mining company or a startup biotech company. You really don’t know much about that borrower and if something happens to them such as a medical emergency then your loan to them might be at risk. You can mitigate this risk by lending using a portfolio plan but I suggest that while this does reduce your risk, it doesn’t change the basic asset class which is still quite risky. A portfolio of p2p loans is like a mutual fund with numerous junior mining companies). You reduce the risk of any one company failing but aren’t protected against events that affect all junior mining companies ie falling metal prices.

One of the big risks that I would be concerned about is if interest rates go up. Presumably people who borrow on p2p are people who can’t get the loan from a bank at a normal rate – I would assume these people have already maxed out their credit or at a minimum have a lot of debt which makes them very vulnerable if interest rates increase.

Same as the old bank

Brip Blap wrote an interesting post on P2P which indicates that the lender “is the bank”. I have to disagree with this because I think Prosper or Lending Club is the bank. The only thing that really changes is that the p2p lender gets to choose who the borrower is which is not the case when you give money to a regular bank to get interest. Another issue I have is that Prosper and CL seem to be spending a lot of money to get clients – advertising, free money giveaways. Where does this money come from? As far as cutting out the middle man – P2P institutions charge for the loans so I don’t really see how they are very much different from banks.

Statistics

Another concern I have is that I think the interest rates are too good to be true. If a borrower is willing to take my money for 10% then I know that they couldn’t get that same loan at a bank. This is problematic for two reasons -

1. The banks are far better at analyzing debtor risk than you or I (too bad they couldn’t analyze subprime securitization loans) so if they don’t feel the person is worth the risk at 10% then you are not getting a deal – you are getting a high risk loan.
2. If the person seems to have reasonable credit then they might have maxed out all their available credit which implies to me that their credit score is meaningless in that situation.

The fact that p2p has not been around very long also means that any default rates are probably understated. A loan can go into default at any time in the three year term so looking at default rates before three years is not going to be very accurate. Also – with the default rates do they do it by time periods? ie years? if not then any new loans will decrease the default rate dramatically.

Taxation

In the US, interest income is treated as regular income for taxation purposes. Dividends and capital gains are given preferential treatment and you will pay less than than on interest. You will be better off taxation wise to have all three of those investment types in a tax-sheltered account such as a 401(k) or ROTH account. If however you have investments in a taxable account then ideally it should not be fixed income such as bonds or P2P loans. Since P2P loans are not eligible for tax sheltered accounts then the extra taxes will reduce returns significantly.

Asset allocation

Asset allocation or the type of assets you invest in (ie stocks, bonds, cash) is a critical step in the investment process. Personally I have 25% of my investments in fixed income and 75% in equities (stocks). Regardless of the expected rate of return, P2P lending is considered fixed income and it should fit into your desired asset allocation.

Basic economics

If something is too good to be true then it probably isn’t. Currently you can get approximately 4% interest on guaranteed certificates or accounts. If you invest in P2P loans and have an expected return of 10% then that puts you in a much higher risk level and there is a reasonable chance that you could lose 10% or more (much like equities).

Bottom line

I have no plans to invest in p2p loans anytime soon because they don’t fit my investment plan. I do want to make it clear that I’m not suggesting that p2p loans should be avoided or that they are a bad thing. If you know what you are investing in and it fits your investment objectives then go ahead and lend away!

This post comes from Mike of Quest for Four Pillars, “another Canadian Financial Blog,” that traces its namesake to none other than the Four Pillars of Investing by William Bernstein.


 Investing 
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Guide to the Sleeping Pill Portfolio

A lot of inexperienced investors who invest in stocks either through mutual funds, index fund, ETFs or owning the stocks directly want great returns with minimal or no losses in the bad times. Unfortunately this isn’t possible for the simple reason that you can’t get great rewards in the equity game without taking great risks. Risk means that your investment could go either way. Your stock fund might get 10% this year or 30% or -30%. In 1929 the Dow lost 90% of it’s value – I’m sure that was a bit of a downer and not just for guys stepping off windowsills.

Should you just buy GICs and not worry about the ups and downs of the markets? I would not recommend that because there is no guarantee that fixed income products will keep up to inflation.
Here are some of the things you can do to invest in the stock markets and get a good night’s sleep at the same time.

Own some fixed income – This could include bonds, gics, high interest savings accounts etc. When the market is crashing this part of your portfolio will hold steady and will reduce your decrease in portfolio value. How much you own is based on your tolerance for volatility.

Diversify – A lot of ex-Enron employees couldn’t sleep at night because their skyrocketing retirement accounts made them giddy – until the company went bankrupt and they were left with nothing. The idea behind diversification is to keep your many eggs in many baskets. If your investment in a buggy whip company isn’t doing so well then perhaps your automaker stocks will make up for it. If your telegraph stocks are dipping then maybe your phone company investments will make up for that.
You need to look at your investments and understand if you are diversified or not.
Things to diversity by are:

* Company – one rule is not to have more than 10% of your portfolio in one company, especially if you work for that company.
* Industry – owning 12 bank stocks is not diversified – The US market has a lot of different industries so buying a broad market index fund or ETF is very diversified.
* Country – although a good part of the S&P500 profits come from overseas – it doesn’t hurt to add some more foreign exposure.
* Currency – this kind of goes with the country diversification. While some people would prefer to purchase currency neutral foreign funds it’s not a bad idea to own different currencies.

Treat your portfolio like a portfolio – When looking at your gains or losses – do it for the whole portfolio and not each security. If you are properly diversified some of the investments will be doing better than others most of the time. If you own ten mutual funds and two of them are cratering but the other eight are doing well then you are doing well.

History – Research the history of the stock market or read the following statement. Stock market goes up, stock market goes down – over the long run, stock market goes up. If you sell when it goes down and then buy on the way up then you are buying low and selling high – don’t do this. Another thing to be aware of is past bubbles – the more you know about them the more you can avoid them.

Keep track of your portfolio performance – If your portfolio goes up 15% per year for the last four years and then drops 20% this year – should you panic? No – you haven’t ‘lost’ anything and your best bet is to hang on.

Ignore the media – The media is not there for your education or to keep you informed. Their job is to sell newspapers, ads etc and that’s it. If the market falls 2% then it’s a “mini-crash”, if it goes up 2% then it’s a “strong day on Wall street”.

I remember someone saying that if you left the design of elevator buttons to the financial media, there would be no “Up” and “Down” buttons – they would read “SOAR!” and “PLUNGE!”.Where Does All My Money Go

This post comes from Mike of Quest for Four Pillars, “another Canadian Financial Blog,” that traces its namesake to none other than the Four Pillars of Investing by William Bernstein.


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