“The surest way to ruin a man who doesn’t know how to handle money is to give him some.”
–George Bernard Shaw
I recently had someone ask me if it was wise to invest in LendingClub or Prosper. For those of you who do not know what these are, they are peer-to-peer lending institutions that usually allow people to borrow money for less than they could at a traditional bank. It’s, generally, because these people have abnormal profiles (read: lower credit scores), so they go the route of peer-to-peer lending instead. These online lenders also claim to be able to offer lower interest rates because they don’t have nice, big, shiny bank buildings and the requisite VP parking spots to have to pay for.
From an individual lender point of view, it is appealing because you get to diversify your risk across lots of small loans. Usually, the loans are in increments starting at $25, and you get to read the dossier on the borrower. The borrower has to provide their FICO information to the platform (e.g. LendingClub or Prosper), and then they get a chance to provide a normative explanation for why they need the money, what they’re going to do, and anything else they can think of to tug on your heart strings or satisfy your inner green visored bean counter that this is a safe loan.
I have a LendingClub investor account, although I’m no longer actively funding – the reasoning which I’ll explain later. I’ll be walking you through my numbers and my results shortly.
First, let me explain why I thought that I could be a good investor in LendingClub:
I actually worked in the credit card industry. While I didn’t do the credit modeling, I was close enough to the process to think I had a pretty good idea of how to look at profiles and determine, reasonably well, the likelihood of getting my money back.
I had the money to invest. While this wasn’t exactly swinging for the fences, it was an alternative risk investment which, if things didn’t work out, wasn’t going to kill me or cause me endless sleepless nights.
How has it worked out so far?
I started investing in LendingClub accounts on March 26, 2010 and stopped funding them on May 26, 2011, investing in a total of 86 notes.
There were times when that number was in the mid-teens, but what the number shows is the projected returns as if people paid their loans on an expected basis. That’s why I expect that number to dip lower over time until I’ve pulled out all of my money.
If you have a large enough sample size, you’ll hit the averages. However, with 86 loans out of a total of 106,138, I’m likely to be skewed by outliers.
This is exactly what has happened. In total, the chargeoff rate for LendingClub accounts is right at 4% (well, 3.99544%). Yet, I skewed in the wrong direction.
I’m not exactly surprised, since I was bitten primarily from dipping my toes into the deep end of the risk pool. Below are the profiles of my charged off loans.
Thus, I wasn’t as smart as I thought I was when it came to picking winners and losers. The reality is that I don’t have enough of a sample size to determine if I was truly skillful or I’d just been unlucky. To have a confidence interval of 95% (2 standard deviations) and be at +/- 1% on my ROI, I’d need 8,807 loans. I was at 1% of the required number, meaning that I can have almost NO idea if I was good or not (there’s a 10.6% confidence interval for those probability and statistics fans out there).
However, it wasn’t the statistical evaluation which made me decide to not invest in LendingClub. It was a moral decision.
By the time June 2011 rolled around, I was putting the final touches on the sale of my company. I knew at that point that I wanted to be a financial planner. I figured it’d be pretty hypocritical if I was going to be running around preaching that there is no such thing as “good debt”, yet be lending people money. Since you can’t just call in the loans, I did the best thing that I could – stop investing in the loans and withdraw money as it became available. That’s what I’ve been doing since June, 2011 and will continue to do so until the account is empty.
“But Jason,” you think to yourself, “I’m not a financial planner! I’m not tied by your constraints! Should I invest in LendingClub?”
Of course, my stock answer is to see your financial planner (ahem…contact me?), since I don’t know your particular situation and, therefore, can’t give personalized advice.
However, I will say this based on my experience. Assuming that I invested $25 per loan, I’d need to invest $220,175 ($25 X 8,807 loans) just to have a 95% confidence interval in my ROI. So, let’s say that I kept that 8.35% return. I could say that 95% of the time, my return would be somewhere between 7.35% and 9.35%, and 5% of the time, it could be goodness knows what. Furthermore, what if I wasn’t as good as I thought, and by the time the results from loan number 8,807 came in, I was down 20%? That’s a lot of money to invest and a long time to wait (up to 60 months) to determine that my particular investing strategy sucked.
“But wait! you think. “Why don’t I just invest in one class?”
We can look at the extremes of population. On the low end (both in population and quality) is the G class. They have 795 loans total, of which 16.2% charged off. To get a statistically significant sample with the abovementioned parameters, you’ll have to invest in 734 of the loans. That’s $18,350.
On the high end is the B class. They have 34,981 loans. You’ll have to invest in 7,535 loans to get a good reading. That’s $188,375.
Therefore, based on the amount required, which, unless your net worth is greater than $4.4 million (assuming you’re trying to achieve a diversified portfolio), you can’t invest in LendingClub or Propser with sufficient rigor to determine if you’re using an appropriate investing strategy and meet my guidelines for taking a shot with your money.
Because of this, you truly are gambling. If you want to gamble and try to earn some money, then be my guest. Just understand that you’re gambling, not investing. I’m not going to beat you up as long as you stay in the guidelines, but, from my point of view, you’d be better off investing that money in one of two ways:
Invest in yourself to make yourself more valuable in your job. If you can get a 10% payraise, then that will compound returns year over year; whereas, with LendingClub or Prosper, you have to continue to find loan opportunities which perform at that return rate. I know which one I think is riskier.
What do you think? Am I too harsh? Have you invested in LendingClub or Prosper? What were your results? Did this article cause you to rethink your strategy? Tell us about it in the comments below!