Why P2P Lending Allocation in Portfolio makes Sense

Peer to Peer Lending is a relatively new asset class in India but has been an active asset class in UK and US for more than 14 years now.

How does P2P lending fit in an asset allocation and what advantage does it provide compared to an Equity and Bond Portfolio?

Let’s see the performance of various assets in USA from 2007 – 2014 which was a very volatile period.

Two things are apparent from the Chart

  • In the short term each assets had it’s troughs and crest and there was no guaranteed investment
  • Over the long term (and even including 2008) stocks did deliver good returns compared to other asset class in the US market.

The Problem with Stock-Only Investing

The problem is that large and mid cap stocks are highly correlated investments. The same goes for other stocks: small caps, international stocks, and emerging markets . If one goes up, the others typically go up as well. As a result an account only invested in stocks tend to be very volatile in the short term .

All stocks(Mid,Small,large, International) move together which can create huge draw downs and can honestly give even the seasoned professionals cold feet.

Ideally, you would invest in places outside of stocks, like in real estate and bonds. These investments are great because they give us a place to put our cash to work that is far less correlated to stock performance. If stocks tank, bonds and REITs are less likely to be affected.

There can be instances when two different asset classes show high correlation as in 2018 between Real estate and stocks as the cause of the recession was real estate itself

Below is the historical correlation of various asset classes in US .

https://d2qh2u5m1l6y4n.cloudfront.net/media/other/howmuchtoinvest.pdf

A correlation value of 1.0 would be a perfect correlation while a value of 0.0 is no correlation at all. So when compared to stocks, peer to peer lending has an average correlation of between 0.13 and 0.19, a very low overall correlation! It should be noted that asset class correlation does change, so it would be great to see how this value changes year by year

For my portfolio P2P is currently yielding 16% and for the last 1 year it has hardly shown any significant correlation with Bonds and Stock market yield.

It has been highly uncorrelated with stocks and bonds. By including peer to peer loans in their overall growth-investments, stock investors are more likely to experience more consistent returns

How did P2P lending perform in 2008 in USA?

We can look at a mature credit industry that did experience this recessions: credit cards. Both P2P loans and credit cards are a similar investment: unsecured lines of consumer credit. And if we take the unemployment rate and stack it against the return that banks earned on credit cards , an informative picture begins to form:

It’s amazing to note that banks still did not lose money on credit cards during the 2008 recession. The stock market fell 57% in six months, yet major banks kept earning and earning.

In short, investors never lost money on credit cards, even during the 2008 recession, the worst economic catastrophe since the Great Depression. But returns did steeply dive by 20-40%, depending on the severity of the unemployment rate.

Thus a portfolio diversified through P2P lending would have performed better than pure equity portfolio

How Much Should You Invest in Peer to Peer Lending?

Minimum Amount:

As P2P lending is based on the principal of diversification I would first put a minimum amount people should invest.

  • If amount to invest is upto 50000 only invest in 500Rs Loan (like Lenden).
  • If 50000 to 150000 , invest in 500 and 1000 loans ,max 2500 (eg lenden, I2I and Cashkumar)
  • if 150000 + then use all platforms with maximum investment no more than 5000.

Ideally 4–5 Lakh is a decent investment size to be diversified across multiple loans and platform.

Allocation Percentage:

P2P lending falls somewhere in between Bonds and Stocks , while they provide stock like returns, the volatility is less like bonds .

P2P lending is high yielding, short duration, uncorrelated investing. Factor which should govern your allocation.

  • How much you have currently allocated to Equity and Bonds .

Most youngsters have high investment in equity and less in bonds as they have a long time horizon.

If someone has 70% Equity and 30% bond they can put 10–15% from Equity to P2P which will make there investment less volatile and also provide some liquidity in short duration.

For People who are in their middle age and have a very conservative portfolio of day 65% bonds and 35% Equity can replace some of the short dated debt funds with P2P lending to increase yield.

There is no sacrosanct number but depends upon your comfort with asset class,how well you monitor portfolio and diversify.

 

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