As I mentioned earlier in the  asset allocation article, for whatever investment, there’s always a relationship between risk and reward. If I want to have a bigger reward, I will almost certainly have to take a higher risk. When building a investment portfolio, it’s always the case of finding the balance between the two, by taking into consideration such factors as investment goals, time horizon, and risk tolerance level, etc., those that are used to determine the allocations of assets in a portfolio. And speaking of building a portfolio, one effective way to mitigate risk and, thus, increase the overall return, is diversification, by mixing up different asset classes that have weak correlations among them.

But what if the investment has only one asset class. Is there any diversification that can be done to reduce the risk the same way diversification does for a stock investment portfolio?

What Is Diversification?

The single investment asset class I am talking about here is Lending Club loans (if you are not familiar with Lending Club, you can read my Lending Club review and subsequent articles to get an idea of how it works). I have been investing for more than a few years already. While I am generally satisfy with the return of my investment, the increasing number of late payments (total 7 out of 206 loans) and defaults (total 5) lately also made me adjust the way I select Lending Club loans to invest, by basically being more selective and investing in high grade loans, in order to reduce the risk. A direct result of the adjustments, and the defaults of course, is that the overall annualized return has dropped to 8.52% among loans I bought directly (not from the secondary market). But is what I did diversification? Well, not really.

To show what I mean, here’s the Investopedia.com’s definition of diversification:

A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.

The key element of diversification is mixing a number of investment options that will lead to higher returns and lower risk. The reason of using more than one asset class is that, if these asset classes are not “perfectly correlated” (meaning they won’t go up or down at the same time), then the return curve of the portfolio will be smoothed out and the combined return will be better than the return of any individual asset class over the long term. Even though perfectly uncorrelated asset classes don’t exist in reality, the theory of diversification still plays a key role in building risk-reward balanced portfolio.

Lending Club Loan Diversification?

Now the question is can I build a diversified Lending Club loan portfolio? My answer is No. Here are my reasons.

From what I can see, all LC loans belong to the same investment class, more or less like a bond fund. Yes, there are different returns in LC loans, anywhere from 6.39% (A1 grade loans) to 21.64% (G5 grade loans), but the loan returns are assigned solely based on the borrower’s credit worthiness, nothing else.  If you would plot the return of each loan category, you would simply get a straight line, maybe with some tiny fluctuations due to defaults. The uncorrelated relationship, which is the key assumption of diversification among different asset classes, doesn’t exist in a Lending Club loan portfolio. Therefore, when you invest in a loan, you will get a fixed return and the overall return of a LC loan portfolio, which may consist of hundreds of loans, can then be calculated, after fees and factoring the overall default rate of all the loan categories. If you really want to reduce the risk (i.e., loan default), the only way is to invest in high grade loans. And when you do that, the return will be lowered. Since the relationship between risk and return is a straight line, you can’t really find a point on the curve that gives you higher return and lower risk, the kind of result that you would expect from a diversified portfolio, when investing in Lending Club loans. The only diversification in Lending Club loans I can do is buying different grades of loans and building a sizable portfolio.

With that said, it doesn’t mean you can’t reduce the risk. In addition to investing in high grade loans which usually have a lower rate of default, you do have to be selective when deciding which loans to fund. However, information provided by the borrower may not entirely be reliable when using such information to make investment decisions. For example, I funded a loan in February that seemed to be a good investment: 714-749 credit score, 1.80% debt-to-income ratio, 8 total credit lines, 15.90% credit utilization, no delinquency, no public record, and 2 credit inquiries in the past 6 months. And the use of the loan couldn’t be better “My son is learning Graphic Design and I need this fund to buy him the System to learn more and better.”

Now you see what I am saying. On surface, the borrower seemed to be at low risk and the loan was for a good use. So I happily funded the loan and hoped to get the 13.85% return of my investment. Unfortunately, it didn’t go as I hoped. What really happened was that after more than three months, I still  haven’t got one penny payment and probably won’t get anything. Luck may play an even bigger role when it comes to investing with Lending Club

Final Thoughts

The role I see Lending Club loans play in a portfolio is as one of the asset classes that are used to build a diversified portfolio. Because the return of LC loans is *fixed*, I can treat it the same as other fixed income assets, such as bonds or cash in savings accounts and assign it a target allocation, the same as other asset classes. Though I may not be able to diversify within my Lending Club loans, I can certainly use it to diversify my investments. After all, the return is still better than bonds or cash in bank accounts with relatively low risk.

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I have been using Lending Club to build a small alternative investment portfolio since early 2009. One of the reasons that I got into peer-to-peer lending, though I have initially resisted the idea, is that the returns I got from savings account were just too low. In the past two years since I started, I have gradually built up my portfolio to 350 loans with a total value of nearly $6,000. It’s still quite small comparing to what we have in the stock market, but quite large in my view given the risk involved in p2p lending.

After two years with Lending Club, I found myself becoming more and more conservative in selecting which loans to fund. It’s not an attempt to diversify because I don’t think you can really diversify Lending Club loans.  Rather, it’s more careful with loan selection. At the beginning, I mostly went after low Grade C & D loans because I wanted to have a better return. That, however, led to a bunch of defaults and charge offs since last summer that severely lowered my return (I currently have 13 defaults). Now, I look for Grad A and B loans most of the time. Though a direct result of being more selective is, again, that the expected return is reduced, I hope it can eventually improve the investment performance. But that’s not guaranteed because there is just so much information you can use to scrutinize a borrower and while everything looks fine on paper, lot of unexpected event could happen and the next thing you know, the borrower passed away, lost the job, or filed for bankruptcy, and the loan defaulted. Those all happened to me at some points.

Anyway, I am trying to explain in the following what I look when evaluating a loan list on Lending Club for those who are interested but are yet in peer-to-peer lending and hopefully get some feedback from others who also invest with Lending Club.

For every listed loan, the details are divided into six parts, including Loan Details, Borrower’s Profile, Borrower’s Credit History, Loan Description, Borrower’s Affiliations, and Questions & Answers. Each part carries some information that can help me determine whether I want to lend my money to the borrower or not.

Loan Details

Loan details give me a quick summary of the loan I am interested in. In addition to loan amount, purpose, monthly payment, grade and rate, and status, I also pay close attention to the percentage of funding received and the total number of lenders committed to the loan since the date the request is submitted. The reason is clear: Since I am not the only one lending money to the borrower (if it’s a large loan, there will be a lot of lenders to fund the loan), I want to get a sense how other people feel about the borrower. Every lender evaluates the loan independently using his/her own criteria and priorities. If a large number of people signed up to fund the loan in a short period of time since it was listed, then there’s a consensus on the trustworthiness of the borrower. And that could make me feel a little bit comfortable about lending the money to the borrower as well. If, on the other hand, a long time has past and the loan is still not fully funded, then I will be cautious too.

The size of the loan, in addition to its purpose, also plays a role, quite an important one actually. Now I generally avoid loans that are $15,000 or more.

Borrower’s Profile

The borrower’s profile tells me the borrower’s employment, homeownership, and most importantly, monthly gross income and the debt-to-income ratio (DTI). According to Lending Club, the DTI is calculated with the borrower’s monthly debt payment obligation (from the borrower’s credit report) divided by monthly income. However, this calculation does not include mortgage accounts or the loan’s expected monthly payment. Honestly, I found this calculation quite weird though. The monthly loan payment as well as mortgage should be included in the DTI calculation in my opinion. What’s the likelihood of making late payment for the borrower who, for example, makes $2,500 every month but has to pay $500 monthly loan payment and $800 mortgage payment on top of $1,000 revolving credit balance? So in the case, I won’t simply look at the DTI and conclude that the borrower has a low debt obligation if the DTI is low. I will instead combine the borrower’s income, monthly payment, mortgage/rent payment, and credit card balance to determine the debt-to-income ratio.

Borrower’s Credit History

In fact, I don’t too much attention to the borrower’s credit score because, as we know, a lot of factores could affect a person’s credit score. If the borrower only has a short credit history, his/her credit score won’t be high, but that doesn’t mean the borrower is not responsible. When reviewing the borrower’s credit history, obvious information such as delinquencies are important, so are the borrower’s revolving credit balance, credit utilization ratio, and recent inquires. A high utilization ratio is alarming, but not necessarily mean the borrower abuses his/her credit (if, for instance, the borrower maxed out a 0% APR card he/she recently obtained, the ratio is likely higher). While I won’t focus too much on the credit score itself, I will, however, try to get a little more information if the borrower’s credit score dropped since the loan was initially listed.

BTW, the borrower’s credit history shows when the earliest credit was opened. I will be more interested in when the latest credit was opened.

Loan Description

The borrower gives potential lenders the story on why the money is needed and what it is for. However, since the description is not verified by Lending Club or anybody, there’s no way to tell whether what were told are true ot not. In general, I’d prefer a borrower tells us a story than those who didn’t say anything. I noticed lately that more and more people are using Lending Club to consolidate their credit card debt by getting rid of high interest rates credit cards and using Lending Club’s low interest loans instead.

Borrower’s Affiliation

Here I can get a feeling of whether the borrower has a stable job, thus a stable income. In this economic environment, layoffs are massive and everywhere. A stable job (if there’s one) means payments are unlikely to be interrupted.

Questions & Answers

If I still have questions after going through all the information above, I can write to the borrower in the Q&A part, asking for clarification. For example, I mentioned that I will take the borrower’s monthly mortgage/rent payment into account when calculating the DTI, but the information is not directly provided in the borrower’s profile. I will need to ask the borrower to give me a number. Actually, I can submit any relevant question to the borrower in the Q&A section. If the borrower clearly answered my questions to my satisfaction, then I will be happy to fund the loan. If the borrower isn’t straightforward, then I’d rather stay away.

Final Thoughts

On one hand, I want to protect myself by avoiding investing in loans that appear to be too risky. On the other hand, peer-to-peer lending itself carries a significant level of risk. During the loan selection process, I want to evaluate every piece of information carefully from the beginning so I won’t regret my decision should something bad happen later. However, there’s no guarantee that a loan will stay current through out the 36-month period. The risk is always there. If you want to get into the P2P lending business through Lending Club, doing your homework (evaluating each loan thoroughly and carefully) may reduce the risk of default of your investment, but can’t avoid it. That’s why you could receive much better return from lending to other people than to banks

So, what’s your way to evaluate Lending Club loans?

Special offer: Now you can get $25 Lending Club sign up bonus to start lending.

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Prosper, one of the leading peer-to-peer lending providers, is celebrating its 5th Birthday on Thursday, February 17th, by making the second payment up to $300 for you if you become a borrower on February 17th and list a loan.

Prosper recently lowered borrower rates. Now individuals with excellent credit can 1-year borrow personal loans through Prosper with rates as low as 5.90% APR (with AA Prosper rating). For 3-year loans, which are very common in P2P lending, the rate for borrowers with AA rating is 6.33% APR and 5-year loans 9.20% APR. For 3-year and 5-year loans, rates for top rated Prosper borrowers are lower than those rates for Lending Club borrowers. The starting rate at Lending Club is 6.89% APR for 36-month loans for borrowers with top rated credit.

The fine print of this promotion:

To be eligible for the offer, you must submit your loan listing between 12:00 a.m. and 11:59 p.m. PT on February 17, 2011, and that loan listing must result in an originated loan. If you meet these criteria, Prosper will credit your second required loan payment up to $300. The credit will be posted to your account within 30 days of Prosper receiving your first payment.

Check out the Prosper promotion and compare its rates with Lending Club’s if you are looking for a personal loan.

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Leading social lending platform provider Lending Club announced early this week that it has lowered the starting interest rate on unsecured personal loans from 7.93% to 6.78% for 36-month term loans (Lending Club also lets borrowers borrow 60-month loans) that could be as much as $25,000. According to Lending Club, the rate cut is “in response to the overall economic environment, and in an effort to continue attracting prime and super-prime borrowers, who typically make decisions based on rates and monthly payments.” The new starting APR for Grade A1 loans, the highest grade loan in Lending Club loans, is nearly half the average starting APR of 13.15%  that borrowers with similar credit can get from credit cards.

The credit squeeze since the financial crisis started in late 2007 has made borrowing from traditional banks very difficult, even for people with good credit. For many who sought personal loans from everything from home renovation to vacation, wedding, even small business, Lending Club has become a valid alternative to obtain an unsecured loan. The company recently said that in August alone, Lending Club has issued 1,175 loans, totaling $12,021,775 to borrowers, the highest amount of loans in a single month in the company’s history.

Borrowing money on Lending Club is quite straightforward, comparing to the borrowing process at a traditional bank. Here’s a quick summary on how it works:

• Borrowers go to LendingClub.com to apply for a loan up to $25,000.
• Once the application is approved, Lending Club assigns a borrower’s grade, interest rate and APR of the loan, based on the borrower’s credit worthiness.
• Lending Club lists loans, together with borrower’s basic credit information such as monthly income and credit score, etc., on its website for all potential lenders to review before making funding decisions.
• Potential lenders choose to fund small fractions ($25 minimum) of hundreds of these loan requests.
• As borrowers pay back the loans, lenders receive the principal plus interest. The average return for investors is 9.67%.

Lending Club loans are currently not available in IA, ID, IN, ME, MS, NC, ND, NE, or TN. Loans are issued by WebBank of Salt Lake City, Utah (FDIC Cert: 34404, insured since May 15, 1997). To borrow money on Lending Club, a valid bank account and borrower’s social security number are required.

If you are shopping for a personal loan, will you consider Lending Club?

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In case you didn’t notice, the price of gold has broken some new highs lately. The latest rally was fueled by comments made after the Fed meeting early this week, which were interpreted by some as signs that more greenbacks will be printed in order to boost the economic recovery that has slowed dramatically in recent months. And that could lead to higher inflation, at least on theory. Gold’s 23.4% appreciation in 2009 was also partly due to the passage of the $800 billion stimulus bill in February. However, as reports from the government have shown, the risk of deflation is actually more real than that of inflation. That did little to discourage from pouring money into gold. Look t the gold price history chart blow. The price of gold has gained 25.8% so far this year and for the past 5 years, gold has appreciated 179.20%.

When gold hit the $1,000 mark in early last year (gold did break $1,000 in early 2008 for the first time, but then was traded lower most of the year), I read quite a few articles on how a gold bubble has formed and where the price could be after the bubble burst. The above chart just shows how wrong those predictions are.

I bought my first piece of gold in early 2007, an American Buffalo gold coin at $685.14, then another piece one year later at $908. With spot gold currently traded near $1,300, which could be broken today, the gold coin and bar I bought seem to be pretty gold investments. But I didn’t buy them as investment, nor do I really think physical gold is the way to hedge against inflation. That said, I did invest in gold through a mutual fund, Tocqueville Gold Fund (TGLDX), long before I own the Buffalo, because I believe gold should be part of a diversified portfolio.

As the predictions of a gold bubble burst have failed and  gold price keeps reaching new highs, investors’ interests in the bullion also grow. If you are interested in investing in gold (there are also predictions that gold will hit $2,000/ounce), there are a few choices to add gold into your investment portfolio.

Mutual Funds

Mutual funds usually don’t own the physical gold directly. Rather, most gold or precious metal funds, such as TGLDX, own shares of gold mining companies. Obviously, the performances of gold mutual funds don’t always correlate to the movements of gold prices. Also, investing in mutual funds requires investors to have an initial investment which can go from $1,000 to as much as $10,000 for Vanguard Precious Metals and Mining Fund (VGPMX), not a small money. The gold thing about buying gold mutual funds is you don’t pay commission fees every time you buy or sell shares, but some do carry front loads. You can use Morningstar Mutual Fund Screener to find gold or precious metal funds, as well as information about initial investments and expenses.

ETFs

If I were to start all over again, I think I would choose Exchange Traded Funds (ETFs) over mutual funds as the way to invest in gold. When I started to buy TGLDX  shares in 2002, spot gold was below $300/ounce. That was like $30/share of SPDR Gold Shares (GLD), which didn’t exist until late 2004. Now GLD is traded more than $126 a share. In my opinion buying gold or silver ETFs is probably the best and easiest way to invest in precious metals because the funds are backed by the physical metals, meaning you own the metals without actually owning them. There are  some several precious metal ETFs available and two very popular ones are GLD and iShares Silver Trust (SLV). You can buy ETFs from any discount brokers the same way you buy stocks. Unlike mutual funds, you do have to pay commissions every time you buy or sell shares of ETFs. Depending on the broker you use, your commission could be anywhere from $0 (with Zecco) to $7 (with Scottrade).

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Gold Coins and Bars

All the three options listed above are good if you don’t want to store any physical gold yourself. If you do, however, want to hold gold coins or bars in your hands, then you need to go to a bullion dealer. There are many dealers out there as well, including those you may find in your neighborhood. After comparing a few gold dealers myself before I bought the Buffalo, I went with Bullion Direct for both the coin and the bar because I found they are quite competitive (APMEX is another choice).

Gold Pool Accounts

I know a few places offer such accounts and one of them is the EverBank Metal Select Account. A pool account is a special storage account where a pool of investors collectively own the gold in the account, thus allowing each individual investor own a fraction of an ounce of the metal in the account. A pool account reduces investor’s cost on storage and insurance as these costs are shared by all investors in the account. If you simply want to trade gold or silver, then a pool account is easies way. Kitco, another major online dealer, also has a gold pool account.

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