When a person starts with social lending then there are several key topics that constantly get mentioned and the importance of diversification cannot be overemphasized by most investors. However, how exactly does diversification work? How does it lower your risk and how should you diversify your portfolio?
diversification – Investopedia defines this as a risk management technique that mixes a wide variety of investments within a portfolio.
With your overall investment portfolio this would be demonstrated by investing into stock, real estate, bonds, P2P lending, precious metals etc. Within your social lending portfolio this means both increasing the amount of unique investments that you have and varying the type of investments that you have in your portfolio. Ideally you should mix both for best results.
How many investments are enough?
Both Prosper and Lending Club have their own set of suggestions about this, but the ballpark number is that you should have about 150-200 investments in your portfolio. The reason for this is that the bigger the amount of investments, the less importance a single investment carries. For example, if you invest 1000€ in 100€ pieces, then each piece counts for 10% of your portfolio. If you invest in 20€ pieces then each piece counts for 2% of your portfolio. It hurts your returns a lot less if one of your 50 loans defaults as opposed to one of your 10 loans defaulting.
People have all sorts of unexpected problems all the time that manifest in their inability to fill their financial obligations. The more different loan pieces you have in your portfolio the safer you are to random movements in the job market or financial markets. Of course, you should take a pick as to what kind of loans you invest into, but up to a few hundred loan pieces having more investments is always better than having less. Once you’ve hit I guess about 500-1000 loan pieces then the importance of diversification in terms of the number of loan pieces drops off quite suddenly.
Essentially there are two ways of achieving this type of diversification. Firstly, you either buy a lot of loans from the secondary market on entry to quickly increase your diversification rate or the other option is to just steadily invest until you have a well balanced portfolio. Currently my portfolio has about 300 loans in it, which means that each individual loan only carries the weight of about 0,3%.
What type of investments should you have?
This is where the diversification strategy that I use gets a bit more complicated from both a philosophical and a rational standpoint. A lot of new investors only want to invest in high grade loans. (In the case of Bondora, those being mostly A1000.) The problem with strategy being the fact that you don’t get all that many loans since everyone wants the best credit grade loans. Something, however, that quite often doesn’t get mentioned is that only forcing investments into the premium credit group actually hurts the diversification or your portfolio.
A look into what the actual credit grades mean demonstrate how this problem comes about. Investing into one credit group also exposes you to one type of people. There are quite clear differences in what kind of people get into the A1000 group in Estonia. You can’t really get there with a low paying job that isn’t in one of the more important fields like tech, law, production, business etc. Investing into the same type of people also means that if a recession were to hit the economy, there are always certain fields that get hit very hard as well.
The recession, that some say is still ongoing, was a great demonstration of how having a good credit rating didn’t mean much in the end. One of the first people to get laid off were all kinds of office workers who tended to have quite well paying jobs and they ended up struggling quite quickly because they were just that used to always having money. On the other hand, people like plumbers, mechanics, teachers, assembly line workers, office managers and other mid-pay jobs were quite safe due to the constant demand that exists for these jobs. Investing into a variety of credit groups also means that your portfolio includes different kinds of people who live in different areas and have different jobs, which makes you less vulnerable in case of a recession.
My diversification strategy in 3 steps
1. Include at least 200 individual loan pieces into your loan portfolio (I currently have about 300).
2. Diversify across different credit groups to minimize risk (I aim to have about 20-25% of my portfolio NOT in A1000 loans).
3. Keep increasing the number of loan pieces you own while keeping the type of loans within my set parameters.