Using peer-to-peer lending to diversify your portfolio
By Luke O'Mahony | Wed 22 Jul 15
By Luke O'Mahony | Wed 22 Jul 15
Diversification is a simple concept: individual investments such as stocks and shares can fluctuate unpredictably. If you’ve picked a winner, you might do very well out of it, but if you were unlucky enough to pick one bad company, you could lose your entire investment.
So, financial advisors suggest (and we agree) that investors should spread their risk by investing across a range of asset classes. That might include some money kept in cash, alongside investing in funds, some bonds and property, for example.
The basic principle is to avoid putting all your eggs in one basket, and, to expand the metaphor slightly, you should also avoid keeping one basket next to another. Diversification only works if your different investments increase or decrease in value independently of each other – they should be uncorrelated.
Let’s say you work at a tech firm. You’ve bought shares in the firm, and have also invested in a few other tech companies. You may consider that to be sufficient diversification, but a tech crash could send stocks in all tech companies, including your own, plummeting – and it could also affect your job.
So, when you consider how to diversify your portfolio, you should consider how correlated your investments are. A useful word here is “hedge” – professional investors might “hedge” their investment in European companies by also investing in South American companies, for example, hoping that a fall in one would be offset by a gain in the other.
As an aside, hedge funds started off by investing in this way, hence the name. Technically, income protection insurance is also a form of hedging – you’re investing in a product which mitigates the risk of losing your job.
Here’s where peer-to-peer lending comes in – over the past five years, returns through RateSetter have been comparatively stable, and don’t “move” in line with UK share indices.
For example, between 13 May and 17 June 2013, the FTSE 100 plummeted from 6,723.10 to 6,116.20, losing 9% of its value in just over a month.
Over the same period on RateSetter, rates remained relatively constant, going from an average of 3.55% to 3.25% (a fall of less than one percentage point) and all RateSetter lenders received their capital and interest as normal.
Crucially, a fall or rise in the market rate doesn't affect your capital (which is to say it won’t lose you money) – it will only affect the amount of interest that you receive in future, unlike changes in stock prices.
Of course, peer-to-peer lending is not a perfect hedge – a huge UK economic crash could ultimately affect returns for lenders if defaults rose dramatically, although at RateSetter our Provision Fund would provide great protection. However, the sector can provide useful investment diversification.
Because RateSetter has been proven to pay consistent returns in the five years since it was founded, it can be a practical way to protect a portfolio from dips and blips arising from other investments – particularly useful if you’re investing for income and need a steady return.
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