Loan Diversification – Don’t Put Your Eggs All in the One Basket
Once you have moved beyond the experimental stage and want to get serious about your p2p portfolio, you will need to think about diversification. Diversification helps a lender reduce its overall risk to any individual loan. Consider the two scenario below:
You start with $20,000 capital, and you lend to two loans ($10,000 each). If one loan defaults, you will incur a 50% loss on your initial capital.
You start with $20,000 capital, and you lend to 20 loans ($1,000 each). If one loan defaults, you will incur a 5% loss on your initial capital. If the remainder of the 19 loans earns a simple interest of 12%, you will still make a small overall profit ($19,000 x 1.12 = $21,280).
Obviously, you want to be in Scenario 2, not 1. You would require some decent amount of capital in order to diversify. But the good news is that Funding Societies allow minimum loan amount of $100 per loan (compared to $1,000 per loan for MoolahSense and Capital Match). So do make full use of Funding Societies to diversify your loans like I do for my personal portfolio (see below).
Selective Risk Taking
Diversification also allows for another neat trick: selective risk taking. Majority of the loans that I select are those that I feel have lower risk. Usually lower risk means lower returns. But if I come across an interesting loan that is slightly riskier but offers a very attractive return, I may decide by putting in a very small amount (like $100). If this loan default, I’m ok because it won’t make a major dent on my portfolio. But if the loan turns out well, I earn a slightly higher return.
One real-life example is lending to construction companies. I normally wouldn’t lend to construction companies because I think the sector is too cyclical. But I have a portfolio of about $18,000 spread across 26 loans. I can afford to lend out $200 to a construction company, if it is a particularly interesting case. Should the loan turn bad, at most I lose $200 out of my $18,000 (about a 1% loss). If the remaining $17,800 earns a simple interest of 12%, then my overall portfolio will still be positive. If this construction loan turn out fine, great!
My actual portfolio – as of Jan 2016
Same Lender, Multiple Loans
One challenge to loan diversification is that some borrowers appear on multiple platforms. So there is a possibility of lending to the same party. I have previously highlighted this before (see here). Currently, there is no easy way to avoid this, except to be diligent in tracking your individual loans. If you know of a good solution, do let me know!
Do also give some thoughts to platform diversification. Platform can go bankrupt too. Weak underwriting at lending platform can lead to higher loan default rates eventually. All the platforms implement different lending agreements, and this represents some regulatory or legal risks. If any the above points sound confusing, it’s because the p2p lending industry in Singapore is very new and a lot of norms have not been established.
Personally, I have done my due diligence on all the three p2p lending platforms (MoolahSense, Capital Match and Funding Societies) and I am comfortable with all of them. I have my favourite plaform. But at this point, I would still prefer to spread my loans across different platforms. This may change in future of course, and I’m waiting further clarity from MAS on how it would regulate the sector. I expect regulation to lead to better protection for lenders.
Finally, I want to leave this post with several open questions for other p2p investors: How are you managing your p2p portfolio? Do you have the same loans as those in my portfolio? What’s your investment style like?
If you are interested in exchanging ideas, do write to me (firstname.lastname@example.org). We can learn from each other. You can disclose as much or as little as you want. Your identity, portfolio and returns will be kept private and confidential at all times.