February 1, 2008

Complete Prosper Diversification

By Prosper

With the economy a bit unsteady, the importance of diversification cannot be ignored. WealthBoy wrote a great post to introduce diversification on Prosper where he observed that a lender should pick up at least 30 different loans to help spread out the risk. Whether you’re diversifying by picking up 30 or 130 loans, it’s important to not just talk the talk, but to walk the walk. If you’re going to diversify, truly diversify.

The power in diversification comes from picking up loans that succeed or fail more or less independently. This independent behavior is characterized statistically by looking at the correlation between two investments. To explore this, travel with me to Sandusky, Ohio for a minute to think through this. Tommy Boy Callahan is about to go on a sales trip to save his family’s auto parts business. If I’m a lender with 30 loans out to all the various employees of Callahan Auto, I’m taking a large risk. If Tommy fails on his trip, all the plant employees will be out of a job, and a very high percentage of my loans will go belly up. In this scenario, there’s a high correlation between one of my loans failing, and one of the other loans failing as well. A lender could have a huge number of loans to the workers, but it wouldn’t do me any good because they’re all likely to fail together. In other words, my 30 loans have only created the appearance of diversification.

To truly diversify, it’s important to distribute those eggs across multiple baskets. Spread loans across multiple states to help avoid local downturns and across different credit grades, incomes, and jobs to target different steps on the socio-economic ladder. By spreading out your lending, you can reduce correlation between loans and reap the benefits of true diversification.

Mike is a Prosper Lender and blogs about Prosper for Prosperous Land.