Peer-to-peer lending is pretty big in the world of personal finance right now. There are a lot of people talking excitedly about the great investment returns they’ve made recently, and of course this has only drummed up interest from others on how to get involved. This is typical of any new investment that’s seen some success, but does it mean that it’s a good thing to get involved with? Today I’d like to share some of my thoughts on peer-to-peer lending and how it might fit into an investment portfolio.
What is peer-to-peer lending?
Peer-to-peer lending is simply the act of one individual lending money to another individual. It’s different from the norm in that instead of going to a bank to get a loan, you’re going to a regular person. It has gained in popularity in the past several years because there are a number of companies who have set up markets where lots of people can do this easily on a large scale.
There is both a social aspect and an investment aspect to peer-to-peer lending. The social aspect is essentially that it feels good to use your money to help someone else out. That’s certainly a valid reason for many, but it is not the focus of this article. My intention here is to focus solely on the investment merits of peer-to-peer lending.
The arguments in favor of peer-to-peer lending
Most of the articles I’ve seen that recommend peer-to-peer lending focus on the good returns they have personally experienced over the last few months or years. The returns I have seen reported recently typically range from 10-12%, which is certainly nice.
I have also seen people argue that they are getting these returns with much lower risk than other investments. This would of course be desirable if it were correct, and I will discuss below whether I believe it to be true.
My arguments against peer-to-peer-lending
I want to be clear up front. I do not think that peer-to-peer lending is necessarily a bad investment. It may have a role as a small part (5-10%) of some people’s portfolios. But I would like to warn against the kind of thinking that happens in situations like this, when many people are excited about a new kind of investment, which is that the investment will only deliver great positive returns without any downsides. On the contrary, I think there are plenty of risks with peer-to-peer lending that people should be aware of before deciding to invest.
1. Recent returns can be misleading
There’s no shortage of history demonstrating that investments can have very strange and abnormal returns over 1, 3, 5 and even 20 year periods. Over the past 13 years, US bonds have outperformed US stocks by 2%. From 2009 to mid-2011 gold returned about 25% per year, and since then it’s lost about 16% per year. Houses were recently seen as investments whose value could only go up. Heck, 17th century century Holland saw a tulip bubble where a single bulb sold for more than most people made in an entire year.
The point is that short-term returns really tell us nothing about what will happen going forward. Once peer-to-peer lending has a long history under its belt (and it has a long way to go), we might be able to understand what to expect from it. But for now, the recent history is fairly meaningless and is actually somewhat dangerous to rely on because of its lack of meaning.
2. All investments come with risk
In investing, better returns only come from a higher amount of risk. It’s a lesson that’s been taught over and over again throughout history, and there isn’t a single example to disprove it (beyond simple diversification). There is no investment in the world that will give you double-digit positive returns without also suffering big losses at some point. It just doesn’t happen and it isn’t realistic to think that peer-to-peer lending will be different.
Peer-to-peer lending has real risks. The people borrowing your money are unable to get loans otherwise because the banks deemed them too risky. You are deciding to take on that risk. It is real and it will show up somewhere down the line. Just recently we had entire banks shut down because the people they gave mortgages to couldn’t pay back those loans. For those people, the consequence for not paying was losing their home. The only consequence for a borrower who doesn’t pay back in a peer-to-peer market is a credit hit. If the default on mortgages was serious enough for banks to go under, you can be sure that at some point your peer-to-peer loans will perform poorly enough to put a real dent in your money.
3. Recent returns have fallen in line with expected risk
Since all investments involve risk, where does peer-to-peer lending rank in terms of risk involved? It’s far too early in its history to say for sure, but my best guess is that it is less risky than stocks but somewhat more risky than investing in junk bonds, which are the bonds issued by the riskiest companies.
While recent returns are not proof of anything, as I talked about above, it is somewhat useful to look at the recent returns from peer-to-peer lending relative to other investments. I don’t have hard numbers (has their been academic research into this market?), but the best numbers I’ve seen reported have been 10-12% over the past 1-3 years. Well, over the past 3 years the stock market (measured by VTSMX) has returned about 18% and junk bonds (measured by VWEHX) have returned about 9%.
This is relevant information for two reasons:
- Returns from peer-to-peer lending have been less than that of stocks and slightly more than junk bonds. That fits right into my guess on risk-level above.
- The returns from peer-to-peer lending really haven’t been anything special. They’ve simply followed the recent trend of risky investments, which has been up. Looked at in isolation, a 10% return sounds great. But when looked at in comparison to other similar investments, it seems pretty normal.
In my view, peer-to-peer lending is a classic example of a new fad that will generate a lot of excitement until it eventually has its big crash and people run for the hills. That’s not to say it won’t stick around. It very well may exist as an investment option for years to come, and if so there will always people who use it as part of their portfolio. But it is not a magic bullet. No investment is.
Before you get involved with any investment, understand the trade-off between the expected returns and the very real risks that are involved. If you’re seeing great returns now, know that there will be periods of rough returns later. You might be okay with that, but it’s a choice that should be made with eyes wide open. And as always, make sure the investment fits into your personal investment plan. Investing in something because other people seem to like it is never a good enough reason. Do your homework and make sure the risks involved align with your overall financial plan.
Image courtesy of nuchylee / FreeDigitalPhotos.net
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