What’s the biggest risk to your investment returns on an annual basis?
Central bank policy? An economic depression? Lying corporate executives? Shoddy advice from your Edward Jones guy? Nope. These are real risks for sure but they all come in a distant second to just one.
Your humanness. There is nothing our humanness loves more than getting involved in something that is being accepted by a large group of people. It’s the ego that wants to be a part of the crowd rather than standing alone and blazing its own trail. Let’s face it, it flat out feels good to be on the side of the majority.
Time and time again, investors readily buy into investment fads only to get their faces ripped off when the fad ends and reality sets in.
I read an article last week, “How Investors Can Earn 7% Returns in a 2.5% World” and I’m convinced it’s the beginning of the end for some unsuspecting investors.
The author, Stephen McBride, discusses the benefits of peer to peer lending as an asset class for investors who want to enhance the yield on their portfolios in light of the current low yield environment.
P2P lending may not wipe out wealth like a good old fashioned financial crisis but there are certainly less risky situations. Bungee jumping in Mexico or “investing” your paycheck in lottery scratchers comes to mind.
This article wasn’t written by a middle-aged guy living in his mother’s basement and it wasn’t published on Bernie Madoff’s blog from the big house, I found it on Forbes.com.
McBride says, “If you want your wealth to grow in a time of rising inflation, you have to put your money to work. With bond yields still near all-time lows—and dividend stocks not offering a much better deal—P2P lending is a great alternative for astute investors.”
I’m not too familiar with P2P lending but I was intrigued by the assertion that it’s a good alternative to dividend stocks and bonds. McBride’s article was heavy on optimism and light on details, so I did some digging in preparation for this commentary.
First, the average loan amount on various P2P platforms, like Lending Club, is $25. Let’s be conservative and say that you have decided to “invest” $20K of your hard-earned shekels in P2P lending to enhance your investment yield. Your $20K would be leant out to approximately 800 people, to fund everything from movie screenplays to food trucks specializing in cuisine from New Caledonia. If the sheer number isn’t enough to make you whence, you are also completely relying on the P2P to provide the due diligence and the screening of the folks that are lining up to borrow your money and be your peer.
Just like any other investment opportunity, you pay to play. Lending club charges 1% on all monthly payments that you receive from your peers to whom you’ve lent money. They also take a healthy amount of fees for any collections process they go through for delinquent payments. On that basis alone, if your return starts out at 7%, like this article suggests, you are already down to a 6% net return before you ever transfer the money to your bank account.
That said, for the technology and access these platforms provide the fees aren’t unreasonable and 800 new friends may be kind of cool. However, there is one detail of this lending that Mr. McBride completely omitted and should scare you away from this yield enhancing opportunity.
Loan Shark Says What?
Mr. McBride says “In 2016, P2P investors earned net annualized returns north of 7%. Even those who took the most conservative approach saw returns of 5%. That’s more than double the average S&P 500 yield.” While this may be true, this statement leaves out the most important aspect of any investment, the risk involved.
This is going to shock you but not all 800 of your peers are going to repay you the $25 you lent them to start their new Cat Tattoo Parlor. Based on data from Lending Club, the default risk of your peer group is not to be trifled with.
Similar to corporate bond ratings, people seeking to borrow money through a P2P platform are rated from “A” to “G.” An “A” rating is lower risk and a “G” is the guy who has 10 credit cards maxed out, no income but somehow manages to buy lottery scratchers every week.
The average return to you, the investor, ranges from 5% if you lend to “A” rated borrowers to over 7% if you lend to borrowers rated “C” or higher. This is fairly straight forward, take more risk, earn more return.
However, the fine print on this statistic is that Lending Club doesn’t charge 5-7% interest. The interest rates charged to borrowers range from 7% for an “A” rating to 14% for a “C.” If the borrower is rated above an “E” they’re paying a vig over 25%. Ouch!
If an investor is lending money at 14% for a “C” rated P2P portfolio, but earning a net return of 7%, this implies a default rate of 50%.
That’s right, 400 of your new peers are going to default on their promise to repay you. If you decided to lend your money to that group of “G” people with maxed out credit cards and an itch for lottery scratchers at 30%, then your default rate rises to 75%.
Look, I know we don’t live in 2005 anymore when money markets earned 5.5% and you could channel your inner Grandmother and lock money up in bank CDs at 7% or higher.
I’m not saying that P2P doesn’t have a place in society. If you want to lend $25 to 800 people like Graham from Des Moines Iowa who wants to start an online company to revolutionize the cat sweater industry, then be my guest. But just so we are clear, it would be more fiscally responsible (and a heck of a lot more fun) to spend that same money on a suite at the Bellagio, a night at the craps table, and bottle service at TAO.
If it’s 7% returns you’re after, I whole heartedly believe there are more effective, efficient, and straightforward ways to achieve that goal.
No rational person is carving out a percentage of their portfolio for peer to peer lending. The risk reward of this type of investing just doesn’t warrant it.
I always emphasize that investors be risk conscious because it is a critical cornerstone of successful investing. No one who is risk conscious believes it’s wise to invest $20K with the risk of losing 75% of that money just so you can have the possibility of earning a 30% return on the remaining $5K and eek out a total return of 7%.
But your humanness doesn’t want to miss out on an opportunity, especially if it’s the latest and greatest. When it comes to investing, I encourage you to go against your “humanness” and what makes you feel good.
Stay data dependent, process driven and most importantly, risk conscious my friends.