Is peer-to-peer lending a good strategy for diversifying a portfolio?

I am 30 years old, single and I earn $42,000 per year. my only debt is my mortgage and a car loan. I have about $60,000 equity in my home and about $9,000 equity in my car. I contribute about 10% of my income to my 401(k) account, and contribute the maximum amount to my IRA every year. Currently I have $80,000 in my 401(k) account, $48,000 in two IRA accounts (Roth and traditional), $8,000 invested in mutual funds apart from my IRAs, $300.00 in my company's stock, and $3,500 in liquid savings.

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.

Co-Published on Investopedia

Co-Published on Investopedia

Peer-to-peer lending would be a good strategy for diversifying a portfolio, but that doesn't necessarily mean it's right for you. The reason P2P Lending is a good diversifier is that a stock market decline won’t necessarily result in a loss in P2P loans. Instead, a P2P loan portfolio will lose value based on whether the individuals pay the loans. As a result, the risk increases based more on unemployment rates than other market forces. So even if the stock market overall drops, if unemployment remains low your lending portfolio may not be significantly impacted.

Although there isn’t enough data to make this determination, there is a chance P2P Lending could have very low correlation with the stock market. Think about how changes in wages impact the stock market vs. how the change would impact a P2P loan. If worker wages increase, this is bad for businesses (stocks) as it increases their costs - but it will increase the chance people can repay their loans. On the other hand, if wages stagnate, this is good for businesses as their costs remain stable - but it will make it harder for people to pay their loans, meaning the P2P portfolio may decrease in value. These reverse influences are what may make the asset class a good diversifier.

Peer-to-Peer Lending Has Additional Risks

All that being said, P2P Lending may not be right for you at this stage. P2P lending, as you correctly pointed out, is high risk. If you have other opportunities to diversify your portfolio with a less risky asset class, you may want to look there first and then add P2P lending after.

In addition to the investment risk, P2P Lending also has risk related to the lack of regulations. One of the advantages of using ETFs and Mutual Funds is they are regulated by the SEC, which gives you more protections as a consumer investor. P2P lending has much less regulation and may lead to higher instances of fraud or predatory practices.

Look For More Regulated Alternatives

You have a strong foundation for your investment portfolio, and are doing very well at planning for and actually executing the plan for your retirement. To determine whether you have opportunities to further diversify your portfolio, you can look at what asset classes your current portfolio is invested in.

For example, if all of the funds invest in different types of Large Cap U.S. stocks, you could add other mutual funds and ETFs which offer greater diversification. Examples include small cap funds, publicly traded REITS (real estate), international stock market funds, emerging market company funds, among others. I chose examples which are higher on the return/risk spectrum to give you ideas, but you could also look at safer investments like different types of bonds. There may even be an opportunity to find a P2P Lending fund.

If You Go Forward, Limit Your Risk

If you do decide to add P2P lending to your portfolio, I would counsel my clients to keep the size of the lending portfolio to less than 5% of their investment portfolio. Based on your numbers, that equates to about $6,800. I don't include equity in homes/cars or liquid savings as these are not part of your investment portfolio (although they are part of your net worth). Keep in mind, this is the high end of what I would generally recommend for a client. Depending on your personal circumstances, I might recommend a much lower amount.

I would also recommend that a client diversify within the P2P lending portfolio. This means making very small loans to a lot of people. This also means looking at the individuals' jobs and locations to make sure the client is not exposed to risks within a particular employment market. For example, if the U.S. government got rid of taxes (just go with the crazy analogy) and all of my loans are to tax preparers, I would have a lot of my loans going bad all at once. The same could be true if all of my loans are with people within a single state or region of the country.

Joshua Escalante Troesh is the President of Purposeful Strategic Partners and a tenured professor of Business at El Camino College. To explore working with him on your personal financial planning and investment advising needs, simply schedule a free Discover Meeting.

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