Guest article: 3 ways to lower your lending risks

In this guest post, Matthew Howard, researcher at 4thWay, the P2P lending ratings agency, shows how to drastically reduce your risk of losses by following his three simple rules.

The most attractive aspect of lending is that it is relatively easy to measure the risks compared to many other investments.

Competent P2P lending platforms are able to say pretty accurately what the chances are of a borrower being unable to repay the entire debt.

But if you lend to just one borrower and that one goes bust, you’re in trouble. So, as long as there is any chance of loss, you need to consider the different ways you can spread your money and risks around.

It’s here that you’d expect me to write about provision funds, yet today this isn’t about how some P2P lending websites have pots of money set aside to cover losses, but about diversifying in three ways to dramatically lower your risks further:

1. Safety in numbers

If a single borrower has, say, a 2% chance of losing you half your money, she’s a pretty good quality borrower. Yet you would probably consider the risks too high to lend to this one borrower alone.

However, if you lend to 100 identical borrowers, your chance of losing a lot of money drops to an incredibly low rate. Instead of having a 2% chance of losing half your money, you have a less than 2% chance of losing just 3%-4% of your money, assuming that market conditions don’t change.

Many P2P lending websites make it easy to spread your money over dozens or hundreds of borrowers. RateSetter offers the widest coverage of all P2P providers by spreading your risk over thousands of existing borrowers in the shock event that its entire provision fund is depleted.

2. Safety in diversity

By spreading your risk across a variety of personal, business and property loans, you ensure that you’re not the one who is panicking if a particular segment of borrowers are hit by a major downturn.

If you’re lending exclusively to the borrowers being hit hardest, the downturn is only more likely to cause you to sell quickly in fear. And it’s when lots of lenders sell simultaneously - outnumbering the loan buyers - that you will have to sell your loans for less than you paid or may not be able to access your money.

Deciding in advance to keep your money spread across many types of borrower also stops you being greedy. Greed will cause you to pile all your money into a single lending sector that, especially at the weaker and less experienced P2P lending providers, is in a bubble. That happens in every other form of investment (think the dotcom bubble) and it will happen to greedy sheep in P2P too.

3. Safety in different investments

Just because I’m stunned by how great the risk-reward balance is in P2P lending, it doesn’t mean I’ve written off the stock market. Not at all. For investors who are willing to invest for a very long time and focus on low-cost share investment funds, the stock market also has an excellent balance between the risks and the returns.

Splitting your money between P2P lending and long-term stock-market investments - with a sensible amount in cash for emergencies and near-term needs - is another way to spread your risks even further. It goes without saying here in the UK that owning your own home is an investment that also usually pays off.

Matthew Howard is a researcher at 4thWay.