P2P Lending Best Practices: The 1% Rule

By buying a piece of many loans, we are creating a loan portfolio for ourselves. This means we need to understand how to manage a portfolio in order to manage our loan portfolios to profitability. We have already talked about Diversification, which is the #1 thing people know and understand about portfolio management in a separate post.

The 2nd Most Important Concept in Portfolio Management

While diversification is #1, the 2nd most important concept in portfolio management is risk management.  How exactly do we manage risk?  How we set up filters and how we analyze credits on our individual loans we select are how we manage risk in our p2p lending portfolio.  Here are some questions we can ask and answer to indicate how we will manage risk:

  • Do you only lend money to homeowners?
  • Do you lend money to people who may be currently delinquent or have a recent delinquency on their credit report?
  • Do you only lend to people in certain states or certain income levels?

These are all questions that you have to ask for yourself and answer to your own degree of comfort.  If you are curious, my answers to these questions are No, No and No but I use my own Credit Analysis techniques. My techniques are what I use to manage risk.

Risk is managed in another VERY important way that we all have to consider: amount of money invested that is at risk. Many of you have decided that once you have a loan or loans that fit your criteria and filters, then you just put $25 into as many of them as you can based the number of dollars you have available.

How do you decide how much you will put into each investment? Please email me at Stu @ p2plendingexpert.com and tell me. I'd like to know.

How Professionals Manage Risk

Professional traders and investors in the stock market use a well known rule of thumb when it comes to managing risk. When they place a trade or make a buy (or buy part of a loan like we are doing), they use the 1% rule.

The 1% Rule simply states that they risk 1% of their total risk capital (total money invested in trades) per trade. The reason for this risk management and money management technique is that professional traders in the stock market are wrong......ALOT. When they are wrong so much of the time, they need the amount risked to be low so they lose minimal amounts when they are wrong and let profits run when they are right and they have a trade that is profitable.

The 1% Rule Applied to P2P Lending

In peer to peer lending ,we already have a built in advantage in that with our investments, we have a relatively low overall default rate. This means our chances of being wrong are already less than a professional stock market trader. However, the low dollar per trade as a risk management technique is still valid and useful for us.

If you applied the 1% rule on a portfolio of p2p loans, then you would need a portfolio of $2500 in order to get started and risk only 1%, or $25 per loan. However, if you are interested and have $1000 to spend, then I would recommend that you get started since the returns seem to be consistent with the new underwriting techniques employed by both platforms over the last couple of years.

For my personal portfolio, I do something close to the 1% rule. Thanks to my private loan, which I also document in my portfolio performance each month that you can access if you Subscribe, the 1% rule for me would be $200 per loan. My standard loan investment is $250, just a little more than 1% (1.25% to be exact) and my reinvestment of interest is done in $100 increments, or a paltry 0.5%.  This is a risk small enough that even our worst enemy, the early payment default, won't hurt me that much.

How do you decide how much you will invest per loan? I'd love to hear how you do it.

 

 

 

About the author

Stu Stu Lustman, the author of this post, is a Credit Analyst by trade trying to bring Commercial Credit Analysis techniques to the world of Peer to Peer Lending. Check me out on Twitter, LinkedIn and Google+

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