From old-school investments in art, wine, antiques or precious metals through niche financial assets such as hedge funds, venture capital and private equity to modern financial innovations (cryptocurrencies!), so-called “alternative investments” have a justified place in many well-diversified portfolios. Owning various, ideally uncorrelated, asset classes decreases risk and volatility and ensures steady returns on your investment. Seemingly, in recent decades and years, we’ve seen spiking demand for non-traditional investments, driven by decreasing trust in financial markets and institutions (blame the crisis) and oftentimes unsatisfactory returns (blame, among other things, low interest rates).
Contrary to most alternative investments, peer-to-peer lending has the potential to move from niche to mainstream and to become a must-have position not only in your individual investment wallet but also within, for example, your pension fund (we highlighted the increasing role of institutions in P2P lending in our post on P2P lending history). In this series of articles, we’ll look how P2P lending compares to traditional financial instruments, the next in the series is P2P Lending vs. Bonds. We start with the backbone of financial markets – the stock exchange. How is P2P lending similar/different, better/worse from investments in stocks? Let’s see.
Differences and Similarities of buying a Stock and P2P Lending
Buying shares on the stock market, you effectively get to own a tiny bit of the company you invested in. Shares can bring you returns in two ways. First, you can make money through asset appreciation – if the company is doing well, its value increases and you can sell your stocks higher than you bought them. Second, you may receive dividends – the company can choose to share a portion of their earnings with the shareholders through dividend payments. Most stocks offer a mix of growth potential and dividend income.
It should be noted that this exact investment pattern has its counterpart in the P2P finance world and is called equity-based crowdfunding but it represents less than 0.5% of the total crowdfunding market so it’s safe to say that it has so far failed to gain significant traction. (You can also buy shares in P2P lending platforms – that’s another piece of the stock market in crowdfunding.)
However, P2P lending itself (or debt-based crowdfunding, which is by far the largest piece of investment cake in the crowdfunding sector), is fundamentally different from investments in stocks. With P2P investment, you offer your money for people to borrow and make profits from the reimbursement of loans with interest. The table below summarises the key similarities (green) and differences (orange) in the ways stock investments and P2P lending work.
Let’s now dive deeper into the comparison and establish the pros and cons of P2P lending compared to investment in the stock market that derive from these fundamental differences.
Pros: Why is Peer-to-Peer Lending so great?
The unpredictability and extreme volatility of stock markets make it not only highly inappropriate for shorter-term investment but also seriously nerve-wracking. You can make good money over the years and then lose most of it within days. During the recent COVID-related slump, the US stock markets lost almost 35% over less than a month, and more than 12% in just one (worst) day. Seeing your savings disappear so suddenly can be hard to handle for many, and potentially lead to emotional reactions that make you lose even more (e.g. selling the stocks low amid the panic).
Investing in P2P loans bears less risk and even less short-term volatility, and yet offers much better returns than traditional “safe investments” such as savings accounts or bonds. It brings steady monthly returns (except for occasional defaults) and therefore, can guarantee a bit more stability and save you a lot of headaches.
Resilience to shocks
Stock prices vary so much over the short term because of their sensitivity to economic shocks, geopolitical turbulences and other turmoil in financial markets (e.g. oil price variation). P2P lending, on the other hand, is largely de-correlated with most asset classes (including stocks and bonds) and much more resilient to external pressures. For example, one study notes that P2P loans “remain durable throughout economic cycles, and can provide a significant boost to portfolio income.”
Even the unprecedented in scale COVID-19 crisis has not affected P2P lending so badly. Of course, many borrowers struggled to repay debts as their businesses shut and salaries got delayed. In general, though, the sector remained resilient, likely thanks to a joint effort of investors (allowing some “breathing space” for pending payments), borrowers (strong commitment to avoid arrears) and platforms (effective use of risk management and debt relief tools, such as provision funds, buyback guarantees, etc.).
P2P platforms are the perfect places to start your investing adventure. For one, they require little initial investment – you can invest as little as $10 in a single loan and with $1,000, you can already easily build a well-diversified portfolio. You can also initially focus attention on P2P lending only – the variety of P2P loans allows you to diversify the portfolio, not having to get involved with other asset classes (e.g. you can pick a range of loans from high-risk high-interest to guaranteed).
Second, the platforms are really easy to use – it takes a couple of minutes to open and verify an account, transfer some money and get started. If you want to use the “hands-on” approach on the stock market, you’ll usually need the services of a stockbroker or bank, which makes it a lot more complicated and costly.
At the end of the day, actively picking your investments can teach you a lot about investing as well as about yourself – how do you react to successes and downturns? Can you handle emotions well? How risk-tolerant are you? Do you enjoy managing your portfolio yourself or would you rather invest in an index fund, sit back and relax?
Cons: Why are stocks so hard to beat?
If you invest with a long-term perspective, stocks are a must-have. Despite their year-to-year, month-to-month, and sometimes day-to-day volatility, stocks will eventually make you money. For instance, the S&P 500 has always posted a positive return over any 20 years in its history. Stocks also significantly outperform almost all other asset classes in terms of returns on investment over longer periods.
We know that stocks are a great investment simply because they’ve been around for so long. We can analyse over 100 years of stock market performance to determine average long-term performance, patterns of fluctuations (or lack thereof), and so on. P2P lending is a new and quickly changing industry. The reliable data on P2P loans reaches only as far back as roughly 2008 and we simply cannot know for sure in which direction it’ll evolve and how it’ll look in 10 or 20 years.
You can withdraw your money from the stock markets in a matter of days if not hours (although please don’t do it in panic when you see the value of your investment plummeting). With P2P lending, although you tend to get some of your money back every month (in the form of credit instalment plus interest), it may take a long time to recover all your funds (depending on the time horizons of loans in your portfolio, usually between 3 and 12 months). Some mechanisms allow you to liquidate your investments more quickly (esp. secondary markets), but you’ll still need some time and fuss to retrieve your money in time of need.
Conclusion: Should you invest in P2P loans?
Both asset classes have their merits. P2P lending is great for those who want to invest over a shorter term and have less capital at hand. It’s also a fantastic educational tool for beginner investors. Stock markets offer sweet returns over the long term for savvy, hard-hearted investors able to stay calm amidst downturns and patiently wait for the reward for 10 or 20 years.
Ultimately, they are just perfectly complementary asset classes. Including both in your portfolio is probably the best way to go. While stocks can bring high returns in good times and over the long term, P2P loans will reduce the volatility of your investments and provide fixed returns over the short term. This role has been traditionally played by income investments or gold (which offer considerably lower returns though) or, most often, by bonds. If you wonder how P2P loans compare to bonds as a “safe” investment, stay tuned for the next article in the series P2P lending vs. traditional financial instruments, in which we look into P2P Lending vs. Bonds.