Understanding social lending returns

A problem that’s been popping up more and more when people discuss social lending is that some people who have experienced some loans going bankrupt are creating a lot of panic about social lending making you lose money. This causes quite a lot of questions about social lending returns that I often have to answer, so I thought I’d go over some frequently asked questions.

How do I tell how much money my social lending portfolio makes?

There are many different “axe” methods that people use. Looking at defaults vs interest earned, looking at interest earned vs portfolio value and any other super simplistic methods. While those can give you relevant feedback about your portfolio in some cases, the only 100% sure way to assess your returns is calculating them yourself using (X)IRR.

This means that you have to use Excel or another data analysis program and run through the numbers yourself. I regularly go through my portfolio returns like this to see how my portfolio is moving.

What about the defaulted loans?

At start defaulted loans hit very hard. If you’ve just started with small amounts then you might not have even made 10€ in interest by the time the first 10€ loan piece has defaulted. This doesn’t mean you’ve made a loss yet – until you’ve made an exit any and all losses are theoretical. This means that unless you sell delayed loans before they default you have to wait for recovery to begin to meaningfully assess how they impact your portfolio.

After two and a half years of investing only four loans so far have made a complete recovery in the value of principal owed with about a dozen others slowly making payments. This means that I’ll be able to assess how well my first loans have recovered by the end of 2016 – and some may not have recovered at all by that point.

What creates high returns for social lending?

The main concept you have to understand when investing into social lending is the fact that your returns start to stabilize as time goes on. The money that gets paid back gets reinvested instantly helping create more returns every month. This means that after a while you start seeing the classical growth curve that starts to curve up more and more due to compound interest working in your favour. This effect is difficult to see if you’re just starting out or your portfolio consists of a small sum of money only.

How to avoid losing money in social lending?

Every investment decision has to be based on a strategic decision. Many people invest into social lending just because it sounds good and its currently popular instead of actually having a strategy or doing any calculations whatsoever. With social lending there are several key points you have to take into account when building your portfolio.

Firstly you need to diversify to at minimum 200 loan pieces as quickly as possible while 500 loan pieces should be your goal. Secondly, the more risky loan groups you invest into, the longer your investment period should be due to the impact of recovery on your returns.

How do I know that my portfolio strategy is working?

Provided that you’re constantly investing you need to also constantly keep track of your portfolio. This means either XIRR, following the growth of defaults and comparing them to site provided averages, assessing interest growth in comparison to portfolio size and other such metrics may be used.

Not a single investment works without additional care, especially not one like social lending that’s new enough that it doesn’t even have a decade of history yet. The credit ratings, the portfolio managers and the overall logic is likely to change, which is why it’s important to keep track of changes.

Do your own analysis, read blogs and newsletters or have an investment group or whatever else necessary. Social lending was and still is a high risk investment, and for that very reason you can’t invest passively even though it’s super accessible to everyone it’s not for everyone.

5 thoughts on “Understanding social lending returns

  1. Tahaks kommenteerida seda, et XIRR (või täpsemini IRR, sest XIRR on lihtsalt tabelitöötlusprogrammi funktsiooni nimi) ei näita õieti mitte SINU tootlust, vaid sinu ja laenajate ühist tootlust. Sina oled oma rahapoti andnud osaliselt laenajate käsutusse, kelle ülesandeks on seda ühist potti intresside maksmise teel kasvatada. Kui suure osa potist laenajad sulle lõpuks tagasi suvatsevad anda, ei tea keegi.

    1. Jah, korrektsem on IRR.
      Nõustun, lõplikku tootlust ei saa teada enne kui kõik laenud justkui läbi oleks, seega ongi väga oluline kasutada laenude aktiivseks olemise ajal mingit mõistlikku meetodit, mitte seda jama mida ma tihti näen, kus hinnatakse portfelli edukust ainult intress miinus punased meetodil. Ajalooline tootlus ei näita küll tuleviku tootlust, aga recovery koha pealt on siiski juba mitu aastat andmeid all, mille põhjal hinnata seda palju võiks tagasi tulla.

  2. An important aspect here is that you should also remember to do your XIRR calculation at the same time of the month or if you do it more often, then only compare the results with others from the same period of month and look at trends.

    The result will differ a lot depending on whether you calculated it in the middle or at the end of the month, since loans tend to become overdue and then current again relatively often around the most popular payment dates.

    But it also makes sense to perhaps understand what XIRR shows you – it calculates your previous transactions and your current situation, based on that considers when and by how much your portfolio has grown and annualizes that growth (gives you a number that essentially says that if this same kind of growth would go on in the same way, you would earn this % each year).

    Since your current situation is changing quite often due to the overdues, then that’s what causes the fluctuations if you calculate it at random times and it won’t be very helpful to look at any single result.

    And just to specify the comments above. XIRR is different from IRR. They’re both mathematical formulas for calculating essentially the same thing, but XIRR (Extended Internal Rate of Return) is used in cases where the payments are made with irregular intervals.

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