9 ways to improve your investing performance in P2P loans

In Blog, p2p lending by Zack Miller8 Comments

Source: Federal Reserve, Prosper.com

Yesterday, I discussed why I’m now a believer in peer-to-peer loans as a new asset class for investors.

Now, I’d like to look at how investors can lower their risks of defaults on these types of loans and boost their overall returns.

The problem with P2P loans

Like in most areas where information is asymmetrical between two parties entering a transaction, p2p loans present an informational problem.

Borrowers know a lot more about their potential to repay a loan than those making the loan.

In a traditional banking relationship, banks have resources to attach a number (a credit score) to a loan. Given experience and data, banks can estimate the probability that a borrower with that number will default. It’s an imperfect solution but works (at least, most of the time).

Borrowers on p2p marketplaces like Prosper.com aren’t given an actual credit score. Instead, they’re grouped into categories of credit worthiness which further complicates our ability as investors to assess their ability to pay us back.

Also, because multiple investors invest in the same loan, each individual investor may lack the incentive to do proper research (free rider problem).  That’s according to Do Social Networks Solve Information Problems for Peer-to-Peer Lending? Evidence from Prosper.com

How social networks help investors better their returns

To mitigate this problem, p2p loan marketplaces have created their own versions of social networks where borrowers can friend people and organizations.

And you guessed it — these groups are key to helping us investors determine the chance that our investments pay off (or don’t).

Why? Because research has shown that borrowers with friends on these investment platforms are:

  1. more likely to get their loans funded (not necessarily a good thing — we want borrowers to get funded and be more likely to pay).
  2. less likely to default on their loans (bingo!)
Why? It’s all about signaling.

The results suggest that verifiable friendships help consummate loans because they are credible signals of credit quality

Source: Judging Borrowers by the Company They Keep: Friendship Networks and Information Asymmetry in Online Peer-to-Peer Lending

We want to invest in loans that provide us with a good return but are also the “right” type of borrower. Using friends and endorsements are key to solving this issue.

We show that borrowers with online friends on the Prosper.com platform have better ex-ante outcomes. This effect is more pronounced when friendships are verifiable and friends are of the types that are more likely to signal better credit quality. The results are consistent with the joint hypothesis that friendship ties act as a signal of credit quality, and that individual investors understand this relationship and incorporate it into their lending decisions. To further pin down why friendships matter, we examine whether friendships are related to ex-post loan outcomes. We find that borrowers with friends, especially of the sort that are more likely to be credible signals of credit quality, are less likely to default.

9 ways to improve our chances investing in P2P loans

1. Find borrowers with good friends

Friendships and networks are an investor’s best friends when investing in the p2p loan space because they’re our best shot at truly judging risk.  “Since borrowers on Prosper.com are only identified by user IDs and otherwise anonymous, friendship ties penetrate this veil of anonymity and lead to a potential for social stigma in case of a default” (Judging Borrowers by the Company They Keep, Lin et al). Look for borrowers with high-quality friends and friends who are also lenders.

Borrowers with a lender-friend are on average 9% less likely to default than those without (Lin, et al).

2. Identify borrowers with friends willing to invest

What better vote of confidence by a friend than him or her taking a piece of a loan? So, look for borrowers with quality friends who are willing and able to invest in them. Invest in people who have other people willing to put their money where their mouths (connections) are.

3. Work with borrowers who went to good schools

Research has shown that borrowers who are members of high quality social groups with particular connections to alumni of an learning institution

we observe better performance and higher returns…if the group is formed based on alumni or other tangible connections (Lin, et al)

4. Find borrowers who live in good geographies

Similar research has shown better performance/lower default rates based upon where a borrower lives.

5. Images sorta matter

One of the thing borrowers can do to complete their profiles is post an image of themselves. Research shows that once a loan is funded, it doesn’t make a hill of beans difference in terms of performance for borrowers with vs. without an image in their profile. That said, having an image may make a borrower more successful in getting his loan funded (for better and for worse)

6. Make mistakes, learn like crazy

There are some incredible resources and tools cropping up in the p2p lending ecosystem. A few of these are incredibly value to help investors scale the learning curve and better their investing returns in p2p loans.  Here are just a few (what else should be included here? Let me know in the comments)

Look for more of these tools/sites to appear as p2p lending attracts more mainstream investors.

7. Narratives matter

Credit scores are just one tool we have as investors to judge whether a borrower will turn out to be a good investment or not. Motivated investors should go beyond just these scores when doing their research. Turns out that investors will do better when they identify borrowers who describe themselves as trustworthy (+1 for the moral compass, baby).

Specifically, lenders should favor borrowers who claim to be moral or trustworthy and avoid borrowers claiming economic hardship.

Source: Tell Me a Good Story and I May Lend Your My Money: The Role of Narratives in P2P Lending Decisions (Herzenstein, et al)

8. Ladder your portfolios with junky short term and higher-quality long term loans

Like good bond investors, it’s important to create a somewhat balanced portfolio.

Source: http://blog.prosper.com/2011/12/20/use-a-ladder-to-climb-your-way-to-a-better-return/

Propser.com has done some research to show that investors perform best if they create a 50/50 portfolio split between loans with 3 year maturities with lower credit ranking (D&E) + 5 year maturities with A&B credit.

The 50/50 portfolio has an estimated yield of 21.82% and estimated loss rate of 8.92%, producing a 12.90% estimated return. Comparing returns to risk, we get a ratio of 1.45 which is almost 46% better than a solely 3-year D & E portfolio. The return-to-risk ratio is a type of coverage ratio that indicates a margin of safety. The 50/50 portfolio offers much more potential coverage, at a cost of lower estimated return by only 2 basis points and 19% longer duration (a measure of a portfolio’s risk exposure to interest rate fluctuations).

9. Learn and improve your returns like crazy

Investing in p2p loans is a similar dynamic to investing in the stock market — there’s a learning curve. So, while you learn, keep your bets small and figure out what works best for you. It turns out, that’s what some of the most successful investors do with P2P loans.

They learn like crazy what works and what doesn’t.

As lenders observe late loans, they tend to decrease their funding of loans in the grade with the adverse shock and increase their funding of higher quality grades. These results indicate strong evidence of learning.

Losing money is a great motivator to learn how to make it. Here’s an example what investors are doing with P2P loans when they lose:

The high late and default rates of E and HR loans have driven lenders away from these loans and toward higher credit grades as lenders have learned about the dangers of investing in these lower credit grades.

Source:  Do Social Networks Solve Information Problems for Peer-to-Peer Lending? Evidence from Prosper.com

What are you going to do?

P2P loan markets offer investors access to an emerging asset class and offer borrowers an opportunity to skirt traditional sources of capital. When I wrote Tradestreaming, VC Michael Eisenberg of Benchmark Capital said he envisioned a day when cash-strong firms like Google or Apple would circumvent banks and get into lending themselves.

In a zero-interest rate world and one where the solvency of a large part of our banking system is being called into question, take a more serious look at P2P loan markets like my favorite, Prosper (that’s an affiliate link).