How Much of Your Portfolio Should Be in P2P Loans for Maximum Returns

P2P loans offer returns so juicy they should get their own sweatpants.

Which is to say a healthy and virile Luchador needs some P2P loans in the portfolio for maximum awesomeness.

We already know Lending Club (LC) and Prosper (P) are excellent hunting grounds for gains – and that’s a good starting point.

But how much of the total portfolio pie should P2P loans be?

Getting the share right is an essential part of making money with these types of investments. Too much, and we open ourselves to unnecessary risk. Too little, and we don’t get enough juicy yields or optimal diversification benefits.

Get the right portfolio allocation to maximize return and diversification benefits with P2P loans.
Get the right portfolio allocation to maximize return and diversification benefits with P2P loans.

Deduction, Dear Watson

When you look at those credit card APR-like yields, it’s tempting to load up on as many P2P loans as you can handle. Like a scrawny teenager at a pizza buffet.

9% or 10% yields?!?! Where else can you find cash spinning off like that?

But, patience, Watson.

Recall our deviant of the 4% Rule – our FL-Approved 3.5% Rule.

A big part of why the 3.5% Rule works to make your retirement long and prosperous is its investment allocation.

It depends upon a portfolio constructed heavily of stocks and less-so of bonds and other investment types. That’s because stocks are battle-tested. They giterdun when it comes to providing for the Luchador lifestyle.

A portfolio allocation of 75% stocks was mentioned as being about right. And, for our purposes here, let’s just go with that. We can fine-tune the overall allocation another time.

That leaves the remaining 25% to deal with. How much of that should be comprised of peer-to-peer loans?

It depends.

It’s all about fit – based on your risk tolerance, time horizon, overall portfolio size, general strategy for retirement (i.e., whether you intend to undertake income-generating activities or not) and your own comfort level with “alternative” investment vehicles.

The bottom line, though, is this.

Between broad-based low-cost ETFs and peer-to-peer loans, the ETFs win every time. They’re more liquid, offer better upside, carry less overall risk and are much more tax-efficient.

Which is why stocks are the foundation of a Luchador’s glistening portfolio.

It’s also why the essential advantage of investing in peer-to-peer loans is the diversification benefit for an otherwise well-built portfolio.

This same summary analysis holds not only for P2P loans but also for all other asset classes relative to stocks. Which is why stocks should comprise the lion’s share of your portfolio.

Correlations and Concerns

The P2P diversification benefit we’re discussing here is separate from the diversity component of taking on 100+ notes on the LC and P platforms discussed in the earlier post on P2P loans.

The diversification benefit we’re talking about here relates to the low returns correlation between peer-to-peer loans and stocks. What a low correlation means is that the ups and downs of the uncorrelated asset classes don’t occur at the same time or magnitude.

Empirical studies show a correlation coefficient of about 0.2 between total stock market returns and P2P loan returns.

From a diversification perspective, this is an excellent relationship. We can enhance our overall portfolio returns by adding peer-to-peer loans to the mix. More on this in just a minute.

First though, because we didn’t get FL-sized financial nuts for being hasty about money, there’s a related issue that heeds mention.

Despite this low historical correlation, there is a risk that things could go south for stocks and P2P’s at the same time. Under certain scenarios, there is an intriguing theoretical argument the returns could move together.

Allow FL to digress here for a moment to slap around this correlation concern since it can be important. Consider the following: The U.S. economy enters a recession, even a very mild and short-lived one. When the recession hits, stock values fall to reflect diminished future anticipated cash flows to shareholders, thus depressing stock prices over some time horizon.

At the same time, because of a dimmed corporate outlook, companies scale back operations and begin layoffs.

What happens to the people to whom you’ve lent money via LC and P? Well, if they lose their jobs and can’t find new work quickly, they enter bankruptcy and default on their loans.

And you would expect the rates of bankruptcy among borrowers on LC and P to exceed national averages as a simple result of selection bias (i.e., all borrowers on LC and P have debt; not all Americans do).

Hence, your LC and P returns would take a hit around the same time as your stock portfolio. Which dramatically reduces the benefits of such diversification since “normal” returns from peer-to-peer loans couldn’t be plowed into a depressed stock market for opportunistic rebalancing.

Such scenario is not so far-fetched and could certainly happen. Yet the risk isn’t captured in the historical correlation coefficients for stocks and P2Ps. This is because P2Ps haven’t been around long enough to have established returns performance during a recession.

Which is why I mention this issue here.

Nevertheless, for as careful as we may be, we at FL are optimists to the core. Large nuts require caution and optimism. We’re cautious optimists, perhaps, but optimists still.

And there’s an essential truth to financial life that warrants repeating: Bad happens way, way less than good.

Over the long run, the returns and profits forgone due to wringing one’s hands on the sidelines always exceed the losses suffered due to being in the markets at a time of difficulty.

10-Spot

With all that out of the way, let’s return to our central question: How much to put into peer-to-peer loans?

The simple answer: About 10% of total portfolio value (or a little less than half of your non-stock holdings).

Empirical evidence suggests the total portfolio returns/risk benefit of investing in peer-to-peer loans maxes out when 12% to 14% of the overall portfolio is in P2P notes.

So, yeah, we could arguably go up to 12% to 14%.

But the personal feeling of FL is that initially allocating 10% of portfolio value into LC and P notes is the right sort of fit. This is for two key reasons.

First, evidence that the diversification benefit of peer-to-peer loans can really help total portfolio returns is pretty good. That makes me want to chew up as much of goodness as possible.

And this benefit starts to really materialize at around 9% to 10% of total portfolio value in notes.

On the other hand, peer-to-peer loans are still a relatively new asset class, with limited historical returns data. What happens to the correlation coefficient during a recession?

There’s also some element of platform risk (i.e., what happens if LC or P run into serious operational trouble…?). Although there are contingency operational plans for these platforms in the event the companies fail (i.e., notes should continue to be serviced), no part of me thinks having LC or P go bankrupt would be good for returns.

So, backing away from the numbers-oriented theoretical optimal of 12% to 14% feels right to me.

There’s some feel-good, intuitive amygdala-stroking that occurs with doing so. And outstanding diversification advantages can still be had when you’re down in the 9% to 10% range, so you’re not giving up much.

Finally, LC and P limit investment for individuals to no more than 10% of net worth. See here (LC) and here (P).

So for us this final point really just seals the deal.

The 9% to 10% level of allocation gives us the best expectation of maximum gains with a low degree of anticipated loss. So that’s a range that just kind of feels “right” all the way around.

The FL-Sized Heaping of P2P

My own portfolio allocation into peer-to-peer loans is closer to 5%.

This is predominantly because I made an initial investment of a little less than 5% when I first plunged into this asset class.

I then added some holdings over time, which has basically kept my allocation at around 5% to date.

Why hasn’t my allocation grown? It’s because, over the same period, my stock holdings grew so much faster simply as a result of capital appreciation and dividend reinvestment.

That’s the kind of portfolio imbalance I don’t mind. But it’s one I need to remedy, so I’ve begun adding new notes at an increased pace – high-yielding notes this time – to my holdings to work up toward a more FL-like target allocation.

My targeted range is 9% to 10%, which it looks like I’ll hit sometime in 2017.

I’ll provide updates from time to time about how things are going en route to the 10-spot. And, I’ll share which peer-to-peer loans platform – i.e., Lending Club or Prosper – is earning my new peer loan investing dollars and why.

But a sneak preview for now: I’ve been test-driving a new investment strategy with P2Ps that I plan to provide some discussion about soon – so far, this new strategy is yielding around 11% returns, so it’s speeding up my rebalancing act just because of its internal cash generation.

Luchadores, what are your thoughts on how much of your portfolio should be P2P loans?

Update: Please read the latest FinanciaLibre post about issues facing Lending Club and the implications for P2P investors, Scandal at Lending Club: Caveat Emptor.

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