I’m currently reading the book, Stocks for the Long Run: The Definitive Guide to Financial Market Returns & Long Term Investment Strategies which is giving me quite a bit to think about. I’d like to share some of my thoughts on overall P2P lending compared to stock market investing and how it can fit into a long-term investment strategy.
The most considerable deciding factor when looking at investments is risk. Much of investment discussion revolves around risk management. Comparing risk of P2P to stocks isn’t apples-to-apples, but there are some parallels.
In P2P when you experience a loss it’s in the form of a default. It’s immediate and realized. Defaults are unpredictable, but past performance can lend some insight into the future. For instance, if defaults are high in a city it would make sense to either increase interest rates for that city, or to avoid it all together. Businesses calculate risk all the time based on past experience, P2P lending should be no different.
If you buy stock A for $100 and it drops to $50, the loss is only experienced when you sell. The stock could have dropped to $50, but rebounded to $100 and then gained to $150. Hence the saying “you only lose if you sell”. Many times people who own stocks that have lost money will simply sell to avoid further loss, or when they feel a stock will never rebound.
There are ranges of risk for both investment types that should appeal to all. If you are looking for safe equities you can buy McDonald’s or Wal-Mart. This would be like buying A(AA) – B grade loans. Likewise highly risky stocks like experimental drug companies may be looked at like C – G(HR) grade loans. Risk determines rewards, or so they say.
Risk is a subject that goes beyond what I am capable of fully understanding or explaining. Just know that the financial crisis we are still experiencing has caused everyone to reevaluate how they look at risk and return.
In summation, can you lose money? Absolutely. About 2.74 percent of people on Lending Club have losses that exceed -25 percent. All-in-all, 10 percent of investors have a negative return to date.
In the book, “Stocks For The Long Run” they make the case that over a 200 year span “stocks have yielded between 6.6 and 7.0 percent per year after inflation in all major subperiods.”
I’ve included returns for the last 100 years.
[table id=5 /]
Total annualized stock return over the last 100 years: 9.53 percent (6.24 percent inflation adjusted)
Anyone care to guess what the returns for 2010-2020 will be? I suspect not 15 percent. If it is, it will be coupled with heavy inflation.
Something to consider is that from 1980 to 2000 we witnessed the biggest bull market period in history. One can reasonably expect the total annualized return to decline over the next decade with respect to 1910 as a starting point.
P2P lending advertises ROIs of ~9-10 percent. These are marketing ROIs that only take into account a portion of newer loans. The reality of the fact is, if you bought every loan ever issued on Lending Club your return would be around 5 percent annualized. Still not bad. Add some method to your note selection and you can get that number to double with little effort.
I always ask the question, “how liquid is a stock portfolio that is down 50 percent”. As I mentioned before, you only experience a stock loss when you sell. This makes it very unpleasant for someone trying to get money out of stocks when they are down significantly. Conversely, with P2P lending this situation is not possible unless 50 percent of your notes are going into default – highly unlikely.
In addition, if you stop reinvesting, within a year you will have close to 25 percent of your account balance back in cash. Of course you can always go to the secondary market and sell your notes. This process can take a number of days – capped at seven before they expire.
If you want to sell your stock, you simply need to issue a sell order and your order will likely be filled at a price near its current value. With P2P it will take several days. Both investments have unique liquidity issues, but you can see how selling notes may have some advantages over stocks.
Volatility and Predictability
This is probably one of the biggest features of P2P. It does not follow the stock market at all, or at least we can not pinpoint any causal links. It’s likely the national unemployment rate is a better indicator of P2P “health”.
Regardless, virtually every day that you check your P2P account there won’t be any surprises. It will increase a little everyday. Defaults take four months to occur, which should give you some time to tweak your investment plan going forward, or even sell the note at a discount. I can reasonably state that when I look at my balance in a year, it will be greater than its present value. I cannot make the same claim for my stock portfolio.
P2P gains are taxed as regular income. It’s taxed the same as bank interest. This is not tax efficient at all. Just like you don’t lose money in stock until you sell, you also do not pay taxes on stock gains until you sell. In order to protect your P2P gains from the tax man you will have to utilize an IRA or write a nice letter to congress begging them to allow long term capital gains on reinvested interest.
IRAs have restrictions in itself like income caps and yearly contribution caps.
“Statistics say that owning just two stocks eliminates 46 percent of the nonmarket risk of owning just one stock. This type of risk is supposedly reduced by 72 percent with a four- stock portfolio, by 81 percent with eight stocks, 93 percent with 16 stocks, 96 percent with 32 stocks, and 99 percent with 500 stocks”
It’s clear that owning a few stocks or better yet, an ETF, will get you diverse pretty quickly.
To be diverse in P2P you need to be spread out among as many notes as possible. It would be nothing short of insane to invest $35K into one loan. To start out, only put $25 (the minimum note value) into each note. Work up from there if you have a larger portfolio. Diversification is one of the primary tenants of P2P investing.
Notes cost nothing to buy. There is however a 1% fee for every repayment. This is less than most mutual funds and actively managed accounts, and probably slightly higher than most ETFs. Stock broker charge a fee for every buy/sell. These fees can become quite expensive for a smaller trader who wishes to actively manage.
P2P lending is much more vulnerable to inflation than stocks. Companies simply raise prices with inflation. Interest rates are fixed. Luckily the longest P2P term is five years, and if you are constantly reinvesting you mitigate against inflation. I track interest rates on both platforms and they are looking good for now.
If stocks are the long-term gold standard for investing, than P2P would seem to be a viable option. All investments carry risk, so I encourage you to do your homework. There are a number of growing resources on the Web and I hope Nickel Steamroller is your starting point.