Diversification: what is it, and why is it so important?

Posted 2 August 2016. Categories: Peer-to-Peer.

Achieving a diversified spread across your investment portfolio can be a key predictor of positive returns - backed up by platform data from heavyweights like Lending Club, as well as industry commentators like Lend Academy, Orchard and Lending Memo. But how does it work, and how much is enough?

Why is diversification important in P2P?

Most people with experience in any form of investment understand the importance of diversifying - not putting all your eggs in one basket. The same applies within most peer-to-peer lending marketplaces.

With the traditional (typically American) model of P2P, where Lenders bear the risk of any defaults, spreading one’s investment across a multitude of loans, avoiding over-representation in any single loan, helps lessen the effect that losses may otherwise have on a portfolio.

Fractionalisation, which is typically employed by most P2P marketplaces, enables diversification to quite a broad level. At Harmoney, for example, all loans are fractionalised into $25 “notes”, and Lenders are able to spread their investment broadly across the marketplace, with as little as a $25 at risk in any one loan.

How does fractionalisation and diversification reduce the impact of losses?

Here’s an example:

Say John and Lucy each have $5,000 that they’d like to invest in Harmoney.

John chooses to split his investment across 2 loans, with $2,500 in each.

Lucy decides to diversify her investment at the maximum rate - investing $25 into 200 different loans.

Both John and Lucy invest in a loan which defaults. John’s portfolio takes a significant hit as a result of the default, because the loan represented 50% of his portfolio. But Lucy’s account is only minimally affected, as the loan only represents 0.5% of her total portfolio.

Now - this is a very simplistic example, but it shows the theory: the more diversified every individual Lender is, the less volatility their portfolio is likely to experience, and the more likely they are to experience a positive return.

Does the data back up the theory?

In short, yes.

Let’s take a look at Harmoney’s data:

individual rar by loans

In the above graph, you’ll see the X axis shows the number of notes invested by an account, while the Y axis shows the Realised Annual Return (RAR). Low on the X axis, there’s a huge spread of volatility in RAR, but as you get higher, that volatility decreases significantly. Harmoney’s current data shows that 100% of Lenders with 100 or more distinct loans in their portfolio are experiencing positive returns. (Check out Marketplace Statistics for more information)

Lending Club’s data tells a similar story - portfolios with 100+ notes, where no individual loan accounts for more than 1% of their portfolio, have a 0.04% chance of experiencing negative returns. Additionally, Lending Club’s data shows a similar result when looking at note count and return volatility.

Lending club volatility

Looking for some other tips on diversification?

We’ve trawled the strategies of industry insiders around the world. Here’s a selection of great articles about it: