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.

Diversification

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.

Photo credit: i love technology

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7 Responses to “Lending Club Loan Portfolio Diversification”

  1. Tom |  Jun 08, 2010 at 11:12 am

    My Net Annualized Return on Lending Club is 7.41% which puts me in bottom 22 percentile of all LC lenders, according to LC. Average is 9.64% they say. (The math: https://www.lendingclub.com/public/lendersPerformanceHelp.action)

    I have only a few loans but all are paid or current going back to Dec 2007.

    I have a dozen Prosper loans going back to August 2007 and all are paid or current.

    I think you can reduce risk and diversify but most lenders do not.

    http://prosperlending.blogspot.com/2007/07/most-prosper-lenders-dont-diversify.html

    • Sun |  Jun 08, 2010 at 10:20 pm

      I don’t have any doubt that you can reduce risk. Within the same loan grades, you can reduce risks by being more selective and avoiding those risky loans. However, this isn’t the traditional diversification in investments that brings lower risk and higher return. In Lending Club loans, lower risk seems to me always means lower return.

  2. Colin Henderson |  Jun 09, 2010 at 10:10 am

    RE: “Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.”

    I would argue that to the extent there is systemic risk across all Americans from economic misfortune you have a valid point. P2P lending ought to be a component of overall portfolio diversification, not the only component in a portfolio.

    Having said that I would say you can still get some diversification across different risk profiles within P@P lending by placing small amounts across many borrowers. This provides some risk mitigation from an unexpected borrower freefall such as Detroit etc.

  3. Darren |  Jun 14, 2010 at 5:41 pm

    Agreed. Loans can’t be diversified from the standpoint of different asset classes that move in opposite directions because they’re all the same asset.

    A person signs up for a loan, and you receive principal and interest in return.

    The only diversification that is done is reducing the possible rate of default, which is done by choosing loans with lower returns.

    In this sense, it’s like a bond fund with different bonds with various grades and maturities.

    • Sun |  Jun 15, 2010 at 9:01 am

      That’s exactly what I meant. As for Lending Club loans, you can’t really find a point where you can get a higher return by adding less risky loans. Of course, you can always be careful when selecting loans even within the same grade by avoiding risky borrowers.

  4. Nic |  Jun 15, 2010 at 4:04 am

    Hi,
    in my opinion your argument is only valid to a limited point.
    You can perform risk mitigation on LC even when all your loans show the same expected return and the same default rate. To understand this, it is necessary to understand the difference between expected loss and unexpected loss. Expected loss is the average loss you assume, prob. by using the stated default rates. E.g. when you invest only in risky borrowers with a poor rating(a default rate of 5%) your expected loss will be 5%. So when lending to 100 borrowers it is quite probable that you will see 5 defaults. But these 5% are not the risk, as you have to expect it. The risk is that you will see higher losses, e.g. 10 defaults. These additional 5 defaults are called “unexpected losses”, which are also called risk (as risk is the deviation from the expected result.).And as borrowers are not completely correlated (as they show a large amount of idiosyncratic risk), you can diversify between borrowers, reducing your risk to the systematic risk, which is quite low for consumers. – Unluckily there are more risk resources, as there exist also model risk and parameter risk. – These are the risks that the assumption of the expected default rates provided by LC are wrong – maybe by purpose to attract investors(I do not hope so..) or just because they do not have enough experience and use only the data from a credit bureau and not from their own population. This risk is substantial and you can’t diversify within LC. And, what is in my opinion the highest risk at LC- the probability of default of LC itself. (I would guess a default probability of about 5%/year for the next 3 years) This can’t be diversified of course by investing in LC alone. And if LC defaults, you will have substantial problems to receive your money back, as you borrow to LC not to the borrowers directly(unsecured notes…). So this risk and this expected loss should also be priced in. P2P lending in US is therefore, based on notes issued by the platforms(i guess the sec is responsible for this approach), a very unattractive investment.
    Just my 2 cents.Nic

  5. James |  Aug 18, 2012 at 3:30 pm

    I think that investors should be aware of the limitations of diversification. Most of the common knowledge built up around the concept of diversification is built on statistics generated from equity markets – my understanding is that similar research has not been conducted on person to person loans, so its an empirical unknown whether in fact diversification leads to less risk and higher returns for loans, per say.