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Why Should I Diversify My P2P Investments?

Posted 8 months ago

Why Should I Diversify My P2P Investments?
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This must seem like common sense but to many, it is still an idea not easily grasped. Our nature as human beings, especially in today’s fast paced environment, makes us want to achieve more in less time. That is why when it comes to managing investments people often like to take the short route, gambling all of their hard-earned money for a quick cash-in. “Don’t put your eggs in one basket!”, a cliched term but one that stands true when understanding how to manage your investments.

The same also applies when managing your P2P investments. Lets look into the reasons why diversification of your P2P investment portfolio is essential.

  • Different types of investments, different risks

The type of P2P investments vary according to the P2P platform that is used. Different alternative financing companies offer different categories to invest in. However, there are basically three main types of P2P investments:

  • Consumer based
  • SME or company based
  • Property based

The consumer based investments (which originally started the P2P trend) attract the most risk and are equally high in yield. The risk here is that the individual borrower defaults and all of the investor’s money goes to the gutter.

The SME based investments involve small loans to mainly trading limited companies. Although less risky than the above category, there is still the risk that the company could go into bankruptcy.

The property based investments involve both individuals and companies but the loans are secured by a charge over a commercial or residential property which the investor has right over in case of a default, thus making this the most risk averse of the three.

A combination of all of the three should be used to diversify the portfolio.

  • Knowing your risk appetite

The major risk in P2P investments is the risk that the borrower will default and one of main obstacles in creating a balanced portfolio is knowing how much you are willing to risk. If an investor has a high-risk appetite, then he will tend to invest higher amounts into higher yield loans and lower amounts into lower yield loans to smooth the returns. But often there is wisdom in taking the safe route.

For example, if an investor were to invest £10,000 into a single loan at 10% per annum for a period of 1 year, he would expect to earn £1,000 in interest.

Total Interest Earned = 0.10 × £10,000 = £1,000

However, if this single investment defaults, he loses all of his £10,000. His rate of return will be -100% (-£10,000/£10,000).

On the other hand had this same investor invested £100 in 100 different loans at 10% interest per annum each, he would still earn £1,000 as above.

Now, if one investment defaults, then he only loses £100 from that one investment and the rest will give him the following return:

Total Interest Earned = 99 × £100 × 0.10 = £990

The rate of return in this case would then be 9.9% (£990/£10,000). Therefore, it can be seen that the principal amount lost due to default of one investment has a minimal impact on the entire portfolio.

  • Long Term Sustainability

Going for high risk loans may bring short term rewards which seem lucrative but this type of strategy is ill-suited if you want to be in the game for the long run. Research shows that long-term loans can get a 2-3% bump in overall interest rates. Therefore, mixing your high-risk loans e.g. to an individual with a long-term loan to a growing company may smooth your overall returns.

Please note: P2P investment involves making loans to small and medium sized businesses and capital is at risk. The principal reason that you may not get all of your money back is if the borrower fails to repay as agreed. Please read the full risk warning


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