September 4, 2008

Diversification

By Prosper

When I search through listings on Prosper, I generally look for loans from borrowers who have really taken the time to give Prosper lenders a good understanding of their financial situation and the purpose of their loan.

After I bid on a loan, I tend to feel so confident that they are trustworthy and credit worthy – I think to myself, “they’ll definitely pay me back.”

But it isn’t as simple as that. Even in rare occasions, the best borrowers can have a huge cost overrun on their home improvement loan. Or their business expansion loan might not be working out, even though everyone agreed the plan was solid.

How can we lenders protect ourselves from losing our money on these seemingly wonderful listings with compelling reasons to bid? Diversification.

Diversification is considered one of the only “free lunches” in finance. It was a concept that changed Wall Street and markets, because for the first time, people realized they could lower risk without lowering expected return.

How might that work on Prosper?  Instead of committing $1,000 to one loan, spread it out. Make 40 bids at $25 each.

In fairness, there’s a good probability that one or more of those 20 loans will have a late payment and maybe (though hopefully not) a default. But even if some of your loans don’t work out the way you wanted it to, your risk is spread around. Losing out on 1 or 2 will be trumped by the rest of your loans performing as expected.

The more you diversify, the more your portfolio’s expected return will be close to your actual return.

In addition to bidding in smaller increments, here are some other ways to diversify using Prosper:

1) Set up a recurring transfer.
When transferring funds to Prosper, I like to transfer $250 a month, which I can do automatically on thetransfer funds screen. Bidding a little bit each month helps to resist the temptation of bidding big on one loan.

2) Re-bid your payments.
Every month when my borrowers make payments to me, I put my money to work by using them to bid on new loans, which further helps to diversify the collection of loans I own.

3) Create a custom portfolio plan.
Creating a portfolio plan that fits the criteria of loans you like to bid on saves a lot of time. Prosper will search for the loans that fit your portfolio plan and automatically bid on the listings that meet the criteria you set.

All of these are great ways to make sure you are diversified rather than putting all of your eggs in one basket. Enjoy your free lunch.


Rohit C. has been a Prosper member since April 2006.