The title of this post is an intriguing question that I saw posted in a discussion group I’m involved in. It’s definitely intriguing because social lending is currently both very accessible for small scale investors and offers much bigger returns (theoretically) than many other investments. This would make it a perfect investment for a quick path to financial independence, would it not? Reality, as always, is a bit more complicated.
What is necessary for FI?
There are two paths for reaching financial freedom. Either you have large enough assets that last you until the end of your life or you have enough cash flow to cover your monthly expenses. Social lending in this case would fall under the second path – you have constant monthly inflow of interest payments that you could transfer out of the portal to use for living expenses. If your portfolio is big enough then at some point you could in theory start selling loans off as well to reduce your portfolio, but this is an unlikely solution.
At current rates of return, you would need a social lending portfolio of about 100 000+ euros to earn enough to live off about 1000 euros (net) per month. (provided you have health insurance, otherwise it’s 1,5x the amount). This number is slowly increasing as returns of social lending drop as the industry evolves. (US sites give us a baseline of 7-10% to plan for in terms of the future). For a similar sum of money you wouldn’t be able to create an equal amount of yearly dividends or rental income (unless you leverage heavily against loans). Why don’t more people focus only on social lending then?
Risk level of social lending
One of the core truths of investing is that higher returns are intrinsically tied to higher levels of risk. This means that while you can enjoy high returns you must be ready to take significant losses as well. In terms of social lending this means that in case of a recession or any other significant economic drop you would potentially lose a lot of your projected monthly cash flow – I wouldn’t be surprised if the drop in payments was something close to half of what is expected. This would give you two options – either dip into the principal amount of your loans to cover your expenses or live off significantly less until recovery kicks in.
Most social lending sites have not gone through a severe recession – the US example only gives us a baseline that’s mixed with the newness of the industry from 2009, meaning it’s hard to project those numbers to the current economic climate. This means that the drop could be far steeper or less steep than expected, however it’s generally best to be prepared for anything when it comes to financial planning.
The reason why most financial gurus and bloggers talk about at least three different asset classes (though they may be very strongly focused on just one), is because it’s a way of balancing out risks. In the case of an economic downfall not all asset classes drop or recover in the same way. If you think of people losing their jobs then the first thing to drop is the commodities market because people start to cut back their expenses. Then it’s a balance between paying off your debts and keeping a roof over your head. People will likely switch to smaller apartments which will influence rental income, and lack of consumer demand will drop stock prices across the board.
This means while one part of the market is already dropping the others will hold steady for a while – the same for recovery. Real estate takes quite long to recover usually, and the same is likely true for loans as well, since bailiffs will take a while to start getting any payments because people will need to find jobs and get their finances back in order. The stock market might go up quickly with euphoria after a severe drop like it did this time around, but recovery might also last years.
For me personally this means that I’m making an effort to diversify my portfolio across different asset classes. While in numbers social lending makes sense in terms of high returns, even I don’t have the risk tolerance to invest only into social lending. Currently Bondora + Moneyzen make up about 60% of my portfolio. Crowdestate, which I would list under real estate (which I know is arguable), is about 10% and the last 30% consists of Baltic stock and SP500 index. In the long run, the value of social lending in my portfolio should slowly start dropping, but it will likely remain at the 50% level for a while.