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I've been interested in peer-to-peer lending for 3-4 years now since I first heard about it with Prosper.com. I've since heard about Lending Club, and this Q/A gave me a lot of insight.

In particular, once answerer says he diversified by dropping $25 in each lending account spread over 270 notes.

This sounds like a good strategy, and its a good anecdote, but almost every other comment on the page seems to be neutral or negative.

If I were to look into P2PL, how should I structure my investments? For example, if I were to invest $1,000 what should I keep in mind when deciding how to divide the investment between higher and lower risk accounts?

  • I don't use these sites, but I did look at Lending Club recently. If you look around on their site, you will see an example portfolio (I think they were willing to construct it for you for a fee). This might give you a good idea of diversification across the various grades of notes. – bstpierre Feb 11 '11 at 19:39
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I'm not sure there's much meaningful diversification at Lending Club across loan quality. The important diversification is to have a lot of different borrowers.

When you talk about diversifying investments, what you're going for is to have uncorrelated asset classes, so when one thing goes down, something else might go up, giving you overall less "noise" and more consistent results.

Across loan qualities, correlation is pretty high I bet. If consumers come under economic strain, you'll get increased defaults at all loan qualities. It isn't like having stocks and bonds, where one might go up while the other goes down. All the loan qualities will (relatively) suffer at the same time, though the lower qualities will (absolutely) suffer more. Anyway the correlation probably isn't perfect so there's probably some theoretical diversification benefit across loan qualities, but I just doubt it's big. Maybe someone else has numbers.

What you do need is diversification across borrowers. All the loan qualities, statistically on average, should have similar returns (slightly more for lower quality). But they get there in a really different way, either lower interest rates with few defaults, or higher interest rates but more defaults. The "more defaults" way is lumpier and should take, on average, more borrowers and more time to average out to the expected rate of return.

Regardless of loan quality, if you only loan to a few people you could easily lose all your money. Important to spread out among a lot of people so you can be fine if some of them take the money and run.

  • Really great answer. I appreciate the explanation and that makes a lot more sense when I realize I'm only "diversifying" my money over a non-diverse crowd. Thanks a lot. – NoCatharsis Feb 23 '11 at 19:28
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You diversify these just like you'd diversify any other investment: invest in multiple notes so that you aren't dependent on the performance of one.

Dividing between high- and low-risk account is also the same as with any other investment: match the level of risk (borrower's credit rating) with the reward (interest rate for the loan) and your personal tolerance for it.

  • Ok, then as a beginning investor - where can I find advice and better detail on the risk/reward/tolerance I would be most comfortable with? – NoCatharsis Feb 14 '11 at 15:07
  • You'll have the best results if you consider each loan individually before you invest. It boils down to how likely you think you'll be paid back. People with lower credit ratings are more likely to default statistically. People with high credit utilization are more likely to default statistically. I found the percentage default rates that Prosper quoted to be almost useless. I'd look around for bloggers who talk about their Prosper or LendingClub investments, lessons learned, etc. Also realize that most of their investment money comes from referral commissions when people sign up. – mbhunter Feb 14 '11 at 15:38
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Not sure if it answers your question - I may have misunderstood - but the UK p2p site Zopa diversifies your investment by lending no more than £10 to each borrower, unless you tell it specifically to do otherwise.

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