Theoretical Long Term Returns of P2P Lending

The chart below lists the inflation adjusted returns for stocks, bonds, bills, gold and the US dollar over approximately 200 years.

Source: Stocks For The Long Run

So what if P2P investing existed in the year 1801 and you could invest one dollar?  What would your returns look like in the year 2006 (the max X value on this chart).

Let’s look at four inflation adjusted returns: 3%, 4.5%, 6%, 7% (roughly 6, 7.5,  9, 10% pre-inflation).

  • At 3% in 2006 your balance would be $428.18
  • At 4.5% in 2006 your balance would be $8,295.44
  • At 6% in 2006 your balance would be $154,064.43
  • At 7% in 2006 your balance would be $1,056.025.55

At somewhere between a pre-inflation return of 9-10% P2P lending performs quite well compared to stock.  What is shocking is how going from 3% to 7% produces almost a 2400x increase in returns.

 “The most powerful force in the universe is compound interest” – Albert Einstein

Happy Thanksgiving!


5 thoughts on “Theoretical Long Term Returns of P2P Lending

  1. I’m having trouble figuring out how FolioFn calculates “Yield to Maturity” on the notes it offers for sale.

    Can you help me figure it out?

    For example,

    Title: 3 year plan – short sale (Loan id: 423543)

    FolioFn lists it as:

    Outstanding Principal: $6.34
    Accrued Interest: $0.02
    Principal + Interest: $6.35
    Asking Price: $6.35
    Markup / Discount: (0.18%)
    Yield to Maturity: 11.59%

    (I tried to pick an easy one where there wasn’t any late or missed payments. If you figure this one out, I’ll try it on a more complicated example. Thanks!)

  2. Not to be pedantic, but the two will behave completely differently.  Different rates of return in large part reflect different levels of risk (variability of those returns).  Risk itself shouldn’t even be thought of only the average volatility of returns.

    Equity is a bit like buying a call option on the upside of increasing earnings, whereas a loan is a bit like a selling put option on some assets of the firm for a fixed premium (like insurance on the assets/collateral).

    Anyhow, if you plot histograms of returns of each, you’ll probably see that returns to lenders are usually less risky and therefore proportionally lower.  Stock returns tend to be more volatile, but you could even control for that by rescaling the plots above to an equal average volatility.  It’s there that it becomes apparent that loans suffer from a bit of a “cliff edge” effect — very little volatility, but when it spikes, it’s probably pretty bad.

    Issuing lots of loans is a bit like selling a lot of hurricane insurance.  You’re returns look great up until the moment they don’t.

    Case in point: Long Term Capital Management’s bond strategies were fantastic until sudden catastrophic loss:

    Ditto for many banks/lenders:

    tl;dr: Volatility and distribution of returns is important to understanding whether their rates are worth the risk.


    1. Brett,
      Risk aside I was focusing only on the returns and some theoretical situations – its still too early to tell where we will be in 5 years. Prosper claims that banks have been routinely making 10% from loans historically. I imagine the return is much less volatile as well. There are huge advantages to this.

      Let’s say you invest 10K in P2P lending and earn 10% a year for two years. And you put another 10K in stock that lose 10% the first year but gain 30% the next. At the end of two years you will be about in the same boat but lets assume at the end of year 1 you needed money. The volatility will make getting your money out result in an immediate loss. You will not have that issue with P2P lending. On the flip side a default is lost money forever. Even a stock that lost 50% of it’s value has a chance of coming back…

      1. I agree that p2p lending represents a very competitive (if not better) investment opportunity compared with traditional alternatives.  Still, I just wanted to emphasize that (a) return-to-risk is more important than average return alone and (b) average volatility of returns is not a comprehensive risk measure for debt-backed securities.

        “Prosper claims that banks have been routinely making 10% from loans historically.”
        It really depends on how you account for it…

        Banks themselves take on leverage and have operating costs and loan losses.  If you want to see their historical ROA or ROI, that’s provided in historical financials.  Their historical equity growth (after accounting for dividends, buybacks, and splits) should approximately indicate their profitability.

        Anyhow, Prosper probably just threw out a nice, round number like “10%” because it seems reasonable enough.

        Also, the situation you described is actually is relates to a common trap that many fall into.  If a loan hasn’t yet defaulted, it doesn’t mean that its risk hasn’t increased and its value implicitly fallen.  If you were then to try to sell the loan, the expected sale price would actually be lower.  Stocks are traded almost continuously in centralized exchanges, so we tend to use mark-to-market accounting to track the unrealized gain or loss in value even if you aren’t trying to sell your shares.  This makes losses seem immediate.  Loans tend to trade in dispersed OTC markets, so we don’t use quite the same rules.  Still, that doesn’t mean that loans haven’t fallen in value as well just because accountants don’t always record the change prior to sale/maturity/default.

        If the expected default rate increases, you’ve suffered an economic loss regardless of whether GAAP or anyone else makes you write it down sooner or later.  Stock gains/losses just hit the books faster 😉

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