Managing Risk in Person to Person Loans 11 years ago

Person to person (or peer to peer) loans pose an interesting opportunity for small investors – P2P lending provides an new and alternative asset class not previously available however this is tempered by a different risk profile for this particular asset class that lenders (who invest in loans) need to be aware of and understand so that they can maximise their returns on investment.

What is Risk?

Risk is the volatility (and associated probability) of an investment, for example, if you invest $100 in blue-chip shares you might find that in any month the price of these shares might rise or fall by say $2 or $3, however if you invest in some small cap mining company the price might jump by say 20% or 30% fairly regularly.

How does Risk Apply to P2P Loans?

An investment in a loan has a unique risk profile…either the borrower repays the loan and the lender gets the agreed full interest rate or the borrower repays late or defaults (cannot pay all of the loan back). P2P loans have a risk profile similar to bonds or other fixed-interest notes where the key decisions for the investor are:

  • What is the likelihood that the borrower will be late or default on repayments?
  • What is the interest rate that I need to apply to this loan to offset the additional risk?

Hence a sensible investor in a P2P loan will need to apply a higher interest rate to¬†‘risky’ borrowers (measured by say a lower credit grade or poor level of information disclosure) to recoup expected late repayments/defaults.

Diversification is Critical for Online P2P Lenders

An investor placing funds into person to person loans should consider the impact of placing 100% of the investment funds into a single loan. If the borrower repays the loan the investor gets exactly what was promised, however if their is a default then the investor less than what was promised. To overcome this asymmetric relationship an investor should always diversify their investment portfolio across a number of loans. The greater the diversification the lower the risk of losses from any single borrower.

Online P2P Borrowing and Lending Platforms

How does the rise of online loans and online P2P borrowing and lending platforms affect the principles for lenders? The exact same principles apply i.e. it is extremely important to assess what is the right interest rate per loan and then to create a diversified portfolio of loans. The benefit of online lending platforms is that they allow you to make quick investment decisions in real time and to invest small amounts in each loan (say $100 at a time) thereby creating a loan portfolio comprised possibly of 10-20 small investments.

If you are interested in further reading on risk and investment risk-return relationships you should check out the Handbook of Fixed Income Securities which has a wealth of financial and investment information.