Is Peer-to-Peer Lending a Good Idea?
I am considering investing in peer-to-peer lending in order to diversify my portfolio. Do you think this is a good idea? I know it can be high risk, and I might not get my principal back. On the other hand, it could pay off in the long term. I won't invest a large sum of money, and it's one way to diversify away from my mutual funds.
Joshua Escalante Troesh, CFP | MBA
Peer-to-peer lending (P2P lending) is a relatively new investment class and tends to carry with it high risk. As a result, I would not recommend P2P lending as a significant part of a person’s portfolio - definitely not more than 5% to 10% of their invested assets. This means you should build up a significant portfolio of more traditional investments before considering investing here.
Adding P2P Lending Isn’t Necessary to Diversify From Mutual Funds
Realize that adding P2P Lending won’t provide significant diversification versus mutual funds and will actually increase the risk of your portfolio (more on that later). Mutual funds and ETFs (funds) aren’t a type of investment but rather a vehicle through which you can invest in investments. As a result, you can accomplish your goal by choosing a mix of funds which invest in different things.
For example, assume your current fund is a S&P 500 index fund. (A safe bet on my part as this is what most books, websites, and supposed financial gurus refer to.) This means you are invested in 500 of the largest companies in the United States.
You could diversify away from this fund by investing in other funds which don’t invest in the S&P 500. A European stock fund, for example, would allow you to diversify away from the American economy. And a government bond fund would allow you to diversify away from the stock market. You could even choose a Real Estate Investment Trust which would allow you to own thousands of rental properties and diversify away from financial securities.
P2P Lending Actually Increases Risk to a Portfolio
P2P Lending carries with it a risk which is inherently difficult to diversify away; specifically the risk the person just decides not to pay you back. While you can lend to numerous people to lower this risk, a significant rise in unemployment would mean a significant number of your loans will go bust. When someone loses their job most people will pay their rent or buy food long before they pay a loan payment on a P2P Lending site.
While it is possible for P2P Lending to lower your risk due to the correlation of P2P Lending to other assets, significant calculations would need to be done to determine if this was actually true for your portfolio and to what degree it helps.
Numerous P2P Lending Scandals
P2P Lending has had a number of scandals recently and many governments have initiated investigations. There have also been less publicised scandals involving P2P Lending sites publishing misleading statistics about returns, repayment rates, and the risk of loans on their platforms.
Get a Second Opinion on the Risk In Your Portfolio
If you are worried about the risk in your portfolio please feel free to schedule a consultation to talk about your portfolio. I have no problem spending fifteen minutes to give you a second opinion on how you are invested and talking about what I might do to lower your risk.