Diversification is defined as the action of making or becoming more diverse or varied. So why is diversification one of the most important words in peer-to-peer lending? To understand this, we need to understand the underlying risks or peer-to-peer lending.
Savings within the European Union are protected up to €100,000 of capital. There are numerous mechanisms that protect savings, but this protection has a cost, which is paid for by the bank and the banking industry. These costs are ultimately passed onto the saver in the form of a reduced return on investment. Unlike savings, peer-to-peer lending does not benefit from this protection, which is why returns are considerably higher, but lenders are exposed to the risk that they could lose capital.
While the risks associated with peer-to-peer lending are smaller than some other forms of investments, lenders on any peer-to-peer platform need to understand the risks to capital that they are exposed to. The primary risk that any lender must understand is the risk that the borrower does not repay the loan. This could be down to many individual factors affecting the borrower such as redundancy, change of circumstances, fraud, bankruptcy or even death. While peer-to-peer platforms will do their utmost to enforce loan agreements, there will always be circumstances where the loan is not fully repaid. In those circumstances, lenders will experience a loss of capital.
Peer-to-peer lending platforms typically publish data on bad debt rates, recoveries and returns after fees. While there is always the warning that past performance is not necessarily a guide to future performance, with historical data we can attempt to quantify some of these risks.
Let us as assume for simplicity that the interest on a peer-to-peer lending platform is 10% over the period of a loan. Let us also assume that for every hundred loans there will be, on average, five loans where the borrower does not fully repay. Let us assume that when the borrower does not repay the borrower fully will, on average, have only repaid half of the capital. From this information, we can surmise that there is a 5% probability that the lender will lose 50% of their capital over the period of the loan. While this chance is small, the effect is significant.
In the above example, if we invest €1,000 in one loan, there is a 95% probability that the loan will be repaid, and we will earn €100 interest by the end of the loan period. However, there is also a 5% probability that instead we would lose €500 capital.
Let us now consider what would happen if we diversify investments over one hundred loans. With a diversified investment of €10 per loan, we would expect ninety-five loans to be repaid. From these loans, we would earn €1 interest each by the end of the loan period. We would also expect five loans to lose €5 capital. The total interest after losses would be €70, which equates to a 7% return.
Using the above example, we could be lucky and only have four loans not fully repay, and our return would increase to 7.6%. Conversely, we could be unlucky and have six loans not fully repay, and our return would fall to 6.4%. Spreading investments over multiple loans will reduce the risk of losing a significant portion of capital to a single bad debt – this is diversification. As we spread our money over a larger number of loans, our return will tend towards the average.
Several peer-to-peer lending platforms, including VIAINVEST, offer additional mechanisms to mitigate the risk or magnitude of losses by providing buy-back mechanisms, provision funds or insurance. Like the protection of savings, there is a cost for these mechanisms, but these will result in a more deterministic return and further reduce the effect of a single bad debt.