A lot has been written about diversification in peer to peer lending, including on this site (see here & here). In short, it is the most important thing investors need to do. Beginner investors sometimes pay too much attention to the details of each individual loan, occasionally forgetting to simply diversify their investment across hundreds of loans. Those who are frustrated by mediocre or negative returns months later, those who feel betrayed, turn, and publicly damn this entire asset class, are almost always investors who simply failed to diversify their initial deposit in enough loans.
The somewhat more debated issue within peer to peer lending has been the threshold at which a portfolio of p2p loans becomes fully diversified. Basically, how many notes does it take? To explore this concept, I reached out to Emmanuel at LendingRobot. He had previously published the below chart that analyzed the completed loan pool at Lending Club.
His data showed the historical crossover point was 146 loans. Basically, (almost) every investor who diversified in 146 equally-valued notes from Lending Club’s pool of completed loans earned a positive return (note: not a guarantee for future performance).
I contacted Emmanuel last month to ask if this point of diversification varied by loan grade. My thinking was that lower risk A-grade loans were probably more stable in their repayments, so the minimum note count to be diversified had probably been historically lower than the other grades. What transpired was a longer email conversation, with the result being the charts seen below.
Probably the most interesting thing this data does is add a bit more nuance to the traditional tenet of 200 notes (Orchard) being the ideal threshold of diversification. As seen in the data below, this number may be overly generous for the safer grades, and too conservative for riskier graded portfolios.
Breakdown of Historical Diversification Points by Loan Grade
Lower Risk Grades
This chart shows that investors who diversified across 60+ completed A-grade loans at Lending Club earned a positive return. This may be incredibly interesting to people like myself who are advocates for others to enter this asset class, since it could offer new investors a much lower trial investment. For some prospective investors, an initial investment of $5000 (200 x $25 notes) is a big pill to swallow. However, if we suggested prospective investors try peer to peer lending with half this amount, perhaps $2,000 (80 x $25 A-grade notes), the trial investment is palatable for a greater number of interested people. Peter Renton actually suggests something similar in his $500 trial investment post.
I imagine the underwriting at Lending Club has improved since these early loans, so this point could be even lower today.
Medium Risk Grades
Here we see the point of positive returns climbing. Within B-grade loans, it is 120 loans. Again, this data indicates that less than 200 notes seems allowed for trial investments as long as a lower degree of risk is taken on.
The overall point of positive returns for all of Lending Club’s completed loans is 146. Finally, in C-grade loans, we have crested this number at 164 and begin to slope downward in any further grades, needing more loans than average for diversification.
Higher Risk Grades
D-grade loans, similar to C-grades, require more loans than average to have an historically positive return: 189.
This is probably my favorite chart of the bunch. Within E-grade loans, we see that 215 notes have been historically required for an overall positive return. This is more than the conventional figure of 200, and points to the fact that diversification is more complicated than typically assumed.
F and G-grade loans never hit a positive minimum threshold. Keep in mind that the note count has also become very low (just 382 & 217 completed loans).
Reflection: Diversification is Complicated
This post really is not a game changer. For new investors who are just starting to invest in online loans, a threshold of 200 notes remains a wise place to begin. However, it seems that prospective investors who are just wanting to try this asset class for a season could open an initial portfolio of fewer notes than 200 – perhaps just 80 equally weighted A-grades, or 150 equally weighted A & B-grade notes. Furthermore, if a new investor is focusing solely on higher-risk loans, 200 notes may not be enough. A better idea might be to shoot for an initial investment of 300 notes or more.
Hearty thanks to Emmanuel Marot and the LendingRobot team for providing these figures.
[image credit: Bob Doran “wildchick17.JPG” CC-BY 2.0]