Diversification of Lending Club Portfolios

Posted by Mike Smith :: October 8, 2007 @ 7:07 am

The idea of diversification means different things to different people. On Lending Club, you can diversify your person-to-person loan portfolio in multiple ways. The rationale behind each type of diversification is ultimately the same: to limit the risk that you take on.

Diversification limits risk by spreading it around to multiple investments. If any one investment doesn’t perform as expected, the overall portfolio of investments will likely still be ok. While diversification also limits gains, to the extent that you won’t have all of your money in your most lucrative investment, the fact that your best investment is generally not known a priori means that diversification is normally the best course of action.

The first way to diversify your portfolio in Lending Club is to lend to borrowers in multiple credit grades. While you certainly have the flexibility to only lend to borrowers in a certain grade, lending to multiple grades will affect both your risk and return. As borrowers’ credit ratings decline, their rate of historical defaults increases. To compensate for this greater risk, a higher interest rate is available for such loans. By taking on loans across multiple credit grades, you are able to average a higher return by taking on wider range of risks.

Another way to diversify your Lending Club portfolio is to loan to more people in smaller increments. If you had $2,500 to lend, you can imagine how your risks would change if you were to loan $25 to 100 people versus loaning the full amount to just a few people. Consider a portfolio of five B-grade loans: While each loan would have a historical default rate of only 0.9%, if one of those loans did default, it would impact 20% (1/5) of your portfolio. One default in a portfolio of 100 B-grade loans would only affect 1% of your portfolio, which is much closer to the historical rate.

To simplify the process of loaning small amounts to many people, lenders can use Lending Match™ to generate portfolios based on their risk tolerance and affiliations. The same method can be used to allocate multiple loans across many credit grades. Even if lenders decide to manually choose which P2P loans to fund, taking a diversified approach will generally yield a more desirable result.