Peer-to-Peer Lending: Follow Rule Number One

Note: This is the second in a series of posts where I’m offering my thoughts as to the role of peer-to-peer (or “direct”) lending within the broader context of the investment landscape.

If you’re reading this, you probably know that I am a major believer in peer-to-peer lending as a viable asset in the majority of investment portfolios.  Today’s post will focus on perhaps the single most important characteristic of this asset class: the protection of principal and preservation of capital.

Warren Buffett’s famous elementary rules of investing are…

“Rule Number One is to never lose money.  Rule Number Two is to never forget Rule Number One.”

Of course, we typically read this as a warning against aggression.  There are lots of ways to lose money by investing it.  People buy assets for more than they’re worth every single day.  They can take on too much debt and watch a portfolio crumble under the weight of leverage.  We can invest in things we don’t understand, only to later learn that the fundamentals were bad from the beginning.  Maybe we’re just bad at poker.  The list goes on – there is no shortage of creative ways to lose money.

The unfortunate reality is that within our financial system of behemoth institutions, decades of savings and investments can be wiped out by occasional shenanigans on Wall Street.  The impact of such events can’t be completely avoided in a properly diversified portfolio – but too much of any bad thing will inevitably result in negative overall returns … which breaks Rule Number One.

This isn’t to say Buffett advocates a strategy of fear – on the contrary, this man made his billions by stopping at green lights and going at red ones.  Independent thinking is a necessity to achieving real returns. Ultra conservative investors will actually lose money in an inflationary environment because inflation outpaces the rate of return on their savings.  Cash and savings are almost always depreciating in value, so we can’t afford to sit still.  If we do, we’re losing money – and breaking Rule Number One.

So how can we follow the rules?  That’s a tough question with lots of moving components and there are plenty of defensible answers – but I contend that peer-to-peer lending (more generally – and better yet – direct, held-to-maturity debt) is a valid piece of the solution.  As of the date of this writing, data published by Lending Club indicate that 99.9% of properly diversified accounts achieve a positive net annualized return, and over 90% of these accounts achieve yields north of 6%.  Arguably Lending Club’s “net annualized return” isn’t the greatest metric for real returns, but the shape of the data is conclusive: virtually all properly diversified peer-to-peer loan portfolios have historically preserved capital and generated yield.

Critical to the argument is that this is true regardless of timing of market entry and exit.  Enter in 2007 when public REIT funds were about free falling?   (…wiping out decades of savings in the process?)  Steady yields of 5%+ across the vast majority of peer-to-peer lending portfolios.  Enter in 2010 when they had a roaring recovery?  Relatively little change in performance in the P2P market.  How about in recent months, when rises in interest rates led to a tumble in bond fund values?  Still yet, the performance of these consumer loan portfolios was effectively unaltered.  Sure, as long as you time market entry and exit right, you probably won’t lose money in public markets in the long run either – but if per chance your timing is off, you can bid adieu to a nest egg.

We’ll talk through why this is true next week – what some of the factors are that dictate such consistent performance – but for now, let’s let the data speak for itself.  A .999 batting average regardless of market timing is pretty compelling to me, and I think it just may help us follow Rule Number One.   Best,

Dan