Lending Club Loan Portfolio Diversification
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
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.
Photo credit: i love technology
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