Each and every investment in this world has a certain degree of risk associated with it, right from a near-zero risk savings account to the riskiest investments like cryptocurrency. The returns, understandably, are always proportional to the risk that the investor is willing to take. The smartest of the investors do not shy away from risk and instead spread their investments across the entire risk spectrum.
While the choice of asset classes is crucial for management of investment risks, the execution of investments in each asset class is equally (or perhaps more) important for effective mitigation of risks and generating great returns. One of the emerging asset classes that are gaining increased attention from the investing class is Crowdlending (also called P2P Lending). This growth in investments in the space is largely fuelled from word-of-mouth promotions by the early investors in Crowdlending, who have been able to generate phenomenal returns over the past few years. In this post, we will discuss in detail the risks associated with Crowdlending and strategies to mitigate those risks to ensure good returns and minimize chances of loss.
Don’t Put All Your Eggs in One Basket
5X-15X returns compared to savings accounts are of course very tempting, but you will be subjecting yourself to huge financial risks by investing your entire money into Crowdlending or any other medium-high risk asset class. The future is always uncertain. We have witnessed everything from triple-digit returns to entire markets vanishing overnight due to regulatory changes. The wisest strategy is to keep your investments spread out across asset classes, from FDs to stocks to relatively risky investments such as crowdlending and so on.
Diversify, Diversify, Diversify
The single most important rule for making profitable investments, especially in asset classes falling towards the higher side on the risk spectrum, is to diversify as much as possible. The same holds true for Crowdlending as well. To start with, it will be prudent to not invest the entire money you’ve decided to allocate to Crowdlending on just one platform. You need to do your research and try to identify at least 3-4 good P2P lending platforms to make your investments in. Such a practice protects you against the possible failure of the lending platforms.
Crowdlending counts among the asset classes that offer almost unmatched possibilities of diversifying your investments. As an investor, you need not commit to funding a full loan. You can choose to fund a small slice of that loan, with many platforms offering an option to invest as little as €5-€10 in a loan. You are advised to make full use of this facility, and make small investments in a large number of loans to reduce the overall impact of a possible default.
Further, almost every platform offers investment opportunities ranging from low to high risk (and proportional returns). To optimize returns while keeping the risk in check, you must spread out your investments across the interest rate spectrum.
Borrower Due Diligence
If you have ever applied for a loan from a bank, you can’t forget the pains of the process and the piles of documents they ask from you. The process, while irritating and cumbersome, is a necessary evil and has managed to keep loan defaults at single-digit figures over the last century. The onus of due diligence, when it comes to crowdlending, shifts to us, the investors. It would be impractical to aim for bank-level due diligence, but using common sense to estimate the chances of a default based on available facts is a better tactic than blindly investing. Almost all the platforms conduct their due diligence before they place loans for investment on their platform, but platforms present different levels of information to investors. It is always safer to go for more transparent platforms that present maximum loan-level information to facilitate decision making.
Lender Due Diligence
Depending on the model of the crowdfunding platform, the loans are either originated on the platform itself or already originated loans are placed by the lenders for investments. Investment in the second category of platforms runs an additional risk of default/bankruptcy of the lender. While investing in such platforms, you also need to research the lender(s) before investing in their loan. Again, exhaustive diligence is not practical, and a look at the lender history, licensing, country of origin and local regulations, loan volume and historical default rates suffices in most cases.
Platform Due Diligence
From nil regulation a few years back, the Crowdlending industry today is subject to ever-increasing regulation. The current level of regulatory requirements, however, is way below the stringent norms for traditional financial institutions. When centuries-old banking institutions can collapse, it is relatively more probable for a crowdlending platform to fail. It is thus crucial for you to put effort and select a few good platforms for investment after due diligence. Platform history (age, volume, default rates, average interest), founding team, VC backing, and media coverage are among the important things to consider.
Most of us have days in our lives when proceeds from the regular source of income do not suffice and we need to tap into our savings/investments. If you count among those who have insufficient liquidity to sail through difficult times, you should avoid longer-term investments in Crowdlending. Some platforms just don’t allow investors to withdraw investments, while some charge huge penalties for premature withdrawals. The best ones facilitate liquidity through secondary markets and buyback options. The choice of platform is also important from this perspective.
Platform Protections against Default
To make their offering attractive to investors, an increasing number of platforms are offering a buyback guarantee in the event of a default. Most of the platforms offer only principal protection, but some rare ones compensate for the loss of interest as well. The presence of this protection on a platform is a big plus, but we need to go beyond the mere presence of this feature and understand the source and operating mechanism to get a true sense of the protection. It is usually better if the guarantee is given directly by the lender. If that is not the case, it means that the guarantee is facilitated by the platform that purchases defaulted loans using its contingency fund. In that case, the ability of the platform to cover for the losses is limited by the size of its contingency fund. You can, thus, give preference to platforms/loans with this feature while keeping the source and operating mechanism in mind.
Another protection mechanism slowly making its mark in the market is insurance. Insured loans are way safer, but only a handful of platforms are currently offering them. Besides, such loans come at significantly reduced interest rates offered to investors. As the insurers get better at quantifying the risks of crowdlending and start offering this protection at better prices over time, this protection mechanism is expected to gain prominence.
No one likes it if their money is sitting idle. Such a situation can arise with crowdlending, even when many of the platforms offer auto-invest options. The platform on which you have invested needs to have a steady flow of loans matching your criteria for that to not happen. You must also set a frequency (monthly or fortnightly) to review the status of investments in all crowdfunding platforms to prevent this effective loss (if we account for inflation) from happening.
Each and every investment is bound to have an associated risk, which is compensated through higher returns. To ensure great returns on the investments, one must practice and perfect the art of balancing risk and returns. Investors, both institutional and retail, today are willing to explore new, emerging asset classes like crowdlending and are reaping benefits. We encourage you to invest in crowdlending while taking care of the above pointers to make your investments less risky and more rewarding.
If you are just starting, please start small and gradually increase exposure as you learn the ropes. To reap true benefits, you need to invest for reasonable periods to gain from the effects of compounding, just like any other asset class. Happy Investing!