What is Diversification?
Diversification is a risk management technique used to create variety in the investments of your portfolio. The idea behind diversification techniques to manage risks resides in the idea that a portfolio with different kinds of investments will decrease the risk, and thereby increase or even out the return in the long run, compared to having only a few individual investments in the portfolio. The goal of diversification is to manage the risk-reward relation, so that the positive performance of some investments neutralizes the negative performance of others. This is done by building a portfolio where the investments are not directly correlated resulting in a better risk-reward ratio. One of the most used bond and stock diversification techniques is based on Markowitz’ Modern Portfolio Theory (MPT).
Diversification in Peer-to-Peer Lending
Diversification in p2p lending is very important since it is a matter of protecting the cash flow from wild fluctuations and instant high impact drops. As a stock investor, buying the 17th or 18th stock will change very little in comparison with a p2p lender being invested in 1,000 loans instead of 100 loans.
There are five main areas to consider when building a diversified portfolio of p2p loans.
Choosing which currency is usually the first one to be considered when limiting the risks and fluctuations in your cash flow as well as limiting the costs of transactions.
The country where you place your investments is usually connected to the currency, but this will not always be the case for example because of monetary unions like that of the Euro and the platforms choice of base currency. With new platforms opening everywhere in the world the opportunities for broad geographic diversification is rising month by month in this high growth market. The geographical placement of your money can have a huge impact on your risks and the diversification of your cash flow.
The p2p platforms operate with two different business models, which involves either one or two middlemen between the lender and the borrower. By using platforms with more than one middleman (both platform and loan originator) the risk management changes drastically as you also have to consider for example buyback guarantee and indirect investment structures.
With lending-based crowdfunding it is possible to invest in car loans, payday loans, loans to real estate projects, SME businesses and much more. All the different loan types carry different risks and lending money across a large range of business sectors and personal loans can create great diversification.
In the end, your cash flow will be determined by the repayment method, which can either be annuity, serial, bullet or interest-only loans.
5 Areas to Consider when Building a Diversified P2P Lending Portfolio
The p2p lending market is growing exponentially these years with more and more currencies becoming available for investing. Currencies fluctuate differently and because of that having loans in different currencies is an important component in a diversified portfolio. The three main currencies in the market are USD, GBP and EUR when excluding Chinese Yen (because of the closed nature of their IT). Most investors use their base currency because of the risk of currency fluctuations and the high fees related to exchanging between currencies. We are aware of at least 20+ different currency denominated loans available for investment in the market.
Peer-to-Peer lending platforms exist on all seven continents with most platforms residing in the United States, United Kingdom, Europe and Asia. The economies and risks are very different across continents and countries, and even if, for example, USA are experiencing are period of great prosper things might go sour in Europe – and vice versa. Most P2P lending platforms in the market can be searched by geography at our page P2P Lending Platforms of the World – so far counting 45+ countries and 20+ different companies.
3. Platform Type
The people behind a p2p lending platform carefully select the projects available for their investors. This means that the differences in risk appetite can be very different. Also, you need to pay attention to the business model of the platform. Lending platforms have business models with either three or four parties involved in the lending process, which means they can carry very different risks that can be managed with diversification. The three party platforms are usually easier to understand carries simple and easy to understand risks, but the four party platforms with an extra middleman is more complex. The outcomes and final results can be very different depending on the platform type, if a borrower or platform goes bankrupt.
Loans on Three Party Platforms (Borrower, Platform, Investor)
Ordinary lending-based crowdfunding platforms, as well as other types of crowdfunding platforms (e.g. equity), consists of a person/company in need of funding, a person/company providing the funding and a platform administrating and marketing the transaction. The investment structure around this process is direct and as an investor you know that you’re the one lending money or buying equity. Diversification between three party and four party platforms explained in the following, will result in different risks.
Loans on Four Party Platforms (Borrower, Platform, Loan Originator, Investor)
In p2p lending specifically, there is another business model with one extra participant, a loan originator. The administration and marketing towards borrowers are split between two companies: The P2P platform and the loan originator. This itself creates another specter of risks. Furthermore, it can involve Buyback Guarantees and indirect investment structures – both more complex and with different risks and even more options for the strategy of diversification. Not only diversifying between both three party and four party platforms will manage the risks differently, but also carefully relying on different guarantees and investment structures will result in different fluctuations throughout the investment period.
4. Loan Type
There are a lot of different loan types in lending-based crowdfunding. When compared to the bond market that consists mainly of very large enterprises and states, it is not only companies that can be lend to, but also persons. In this market it is possible to buy fractions of loan contracts in both business lending and personal lending exposing oneself to different risks.
Examples of Business Lending
- SME (Small and medium-sized enterprises) loans
- Real estate/Property loans
- Receivables/Invoice financing
Examples of Personal Lending
- Consumer/pay-day loans
- Car loans
- Mortgage loans
5. Repayment method
How will you get the repayments/installments when the loan is paid back? Will you receive an equal sum every month, the whole amount in the end of the loan or in series throughout the loan’s duration? This is defined by the repayment method and how it is structured. As a lender, it will impact the risk of your incoming cashflow, liquidity and flexibility in the market.
The annuity loans are characterized by equal amounts of installments throughout the repayment period. As the loan is repaid the interest portion decreases and the portion of the loan repayments increases. Because of the amortization this product offers lenders a continuously similar cashflow throughout the whole loan period.
With a serial loan the interest portion is the same throughout the entire repayment period. This means that the interest and the instalment amount decrease as the loan is paid back. This product offers lenders a larger cashflow in the beginning of the loan with smaller and smaller returns throughout the loan period.
Compared to the two other methods, bullet loan repayments are not due throughout the loan period. Instead it requires one large payment made by the borrower at the loan’s maturity. This product will typically require higher interest rates to the lenders, because it do not offer flowing cash from repayments throughout the loan period. Bullet loans are generally structured as either an interest-only loan (paying interest periodically throughout the loan) or as a full lump sum payment (loan and interest paid all together at the end of maturity).