When I was younger I would always talk about how Apple’s stock was going sky rocket on the day of a release event. After a few of Apple’s annual product release events I noticed a disappointing trend. The stock never really did anything that day, in fact, sometimes it dropped! This baffled me. One day I was talking to my friend, let’s say his name is Jeff (although his real name is Erik). He told me anticipation of the release of some new awesome product was “already priced in” into the stock price.
Jeff would go on about how every piece of public information and even speculation was already built into a stock price, and that price is exactly how it should be priced. Interesting stuff.
“In finance, the efficient-market hypothesis (EMH) asserts that financial markets are “informationally efficient”. That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made”.
So basically we should stop trying to beat the market because it’ll be a waste of time. In fact there is an entire investment company predicated on this idea, and all they they do is basically buy stocks like VTI that mimic the entire global market.
EMH Example For P2P Loans
I’m going to use a simple example, inquiries in the last six months. For some reason the ROI is almost perfectly negatively correlated. As the inquires go up, the ROI goes down. For the best returns you should always set this value to 0 on your filter… For now…
What if because of blogs the word gets out that you should always set inquiries to 0. Let’s get a little crazier with the example and say they even start to talk about this on the 10 o’clock news to the point everyone knows this. What would happen? No one would buy notes that have a borrower in excess of 0 inquires. Obviously there will be people with more than 0 inquiries that need money. What would happen? The P2P platforms would have to raise interest rates on these to a point where lenders would start to fund them again. You can see here how the market in essence re-priced the loans correctly. Pretty efficient stuff!
Emotion Introduces Inefficiencies
I personally believe EMH contains only half of the equation. The other side is our emotions. Emotions compound the volatility of the markets. How many times did you or someone you know pay too much for a house, an item on eBay or a car. This is identical to how the stock market works with bid and ask prices. In the last 5 years we’ve also seen swings in excess of 10% as a result. Prosper 1.0 was based on an auction system and did not provide good returns overall. Personally, I don’t think there was anything wrong with the Prosper 1.0 model, it was simply too small and ended to soon to lower variance enough to be more “efficient”.
The (Huge) Fixed Rate Advantage
Because both platforms have removed the emotional/auction aspect by setting the rates P2P lending turns out be much more efficient than the stock markets, which shows up in the stable returns. The the only place inefficiencies show up in masses is on the secondary market. Let’s say my same friend Jeff thinks that P2P market is going to collapse, he can “dump” all of his notes onto the secondary market for a bargain price. Some lucky people will pick up some deals and perhaps beat the “market average” for those loan grades.
There are actually a lot of parallels between stocks and notes. You can think of the P/E ratios, earnings yields, market caps of the Stock Market as being the inquiries, loan grades and sizes of the P2P market (maybe in that exact correlation). All of the filter options we have when picking notes are effectively valuations. That’s where the similarities end.
Prosper and Lending Club set rates putting lenders at a huge advantage over investing in the stock market. This allows us to see how filters impact ROI in an objective manner. What’s also neat is the LendStats model factors in every loan’s performance so it reflects every available piece of information available to us. How efficient is that!?