In the last few years Direct Lending (which includes Peer to Peer lending) has started to move away from the umbrella label ‘alternative finance’ establishing itself as an increasingly mainstream asset class in its own right.
Whilst there is no argument that an increasing number of investors are using Direct Lending and P2P lending as part of a balanced and diversified portfolio, there are still a significant proportion of retail investors holding off from trying it out; despite the ‘saver unfriendly’ climate we are currently in.
What is the main obstacle to investing in Direct Lending?
So, what is it that is stopping retail investors from putting some of their investment capital in Direct Lending? We asked that very question to City AM readers. Responses1 indicated that the 'riskiness' of the return was the key investment obstacle:
- Too Risky (30%)
- Unproven returns (19%)
- What is Direct Lending (19%)
- Too Time consuming (16%)
So how risky is Direct Lending – is it ‘Too Risky’ for everyday investors? To answer this, we’ll take a closer look at the risks investors are exposed to.
Risk - Unavoidable and Avoidable
Investment risk probably falls into two categories – risks that are ‘unavoidable’ and risks that are ‘avoidable’:
1. Unavoidable Risk
The very nature of investing involves an element of risk . This is one of the key differences between ‘saving’ and ‘investing’. If you want to target a better return than you can currently achieve in a traditional high street savings account, then the reality is that you should be willing take on a level of risk. Direct Lending is no different to any other investment option in the sense that there are risks inherent to this asset class that can’t be avoided:
- Your money is not protected by the Financial Services Compensation Scheme (FSCS). For example, if a lending platform collapses you are not be eligible for FSCS compensation.
- Your capital is open to losses. Loans can default and you may not get back some or all of your investment.
There are of course ‘levels of risk’. As a rule of thumb the higher the rate of return the higher the level of risk (and if something looks too good to be true, then it might well be so you may want to steer clear). As with any investment the key is to understand the potential pitfalls and to make informed decisions to help mitigate those risks - leading us neatly on to ‘avoidable’ risk.
2. Avoidable Risk
Unlike the ‘unavoidable’ risks we’ve outlined above, there are risks that you can avoid through making sensible and informed choices.
Don’t put all your eggs in one basket
Spreading risk by diversifying your lending portfolio is one of the most effective ways to minimise the impact of any losses. Essentially, don’t put all your eggs in one basket; spread your money across a number of different loans, loan types and lending partners. The more you can diversify the higher the probability of you being able to protect some, if not all, of your capital. For example, a loan portfolio with 100+ loans should better protect you from downside risks compared to a loan portfolio of just 50 loans.
Thoroughly research your lending partners
Researching your lending platform is essential. Not all lending platforms operate in the same way and although low barriers to entry has opened up the market, offering investors more choice, it has meant different levels of standards. It is also important to bear in mind that although FCA regulation can serve as a helpful indicator, it doesn’t necessarily guarantee the quality of a platform, its loans or its returns.
Focus on looking for lending platforms with teams that have solid experience in credit and investment and that are transparent in terms of their past investment performance. A strong investment team will understand how to source quality loans and how to manage them.
Careful loan selection
Focusing on asset-backed lending can limit your exposure to unsecured lending and may help protect your return. Find out who is borrowing. For example, are you lending your money to a business or an individual and what is the loan used for – this will help you identify loans that could go bad.
Only invest what you are comfortable exposing to risk
Diversify your portfolio and don’t put all your available capital into any one type of investment. For example, most experienced investors invest no more than 30% of their available investment capital in P2P lending. As with any investment, be sensible and only invest a proportion of what you are comfortable exposing to risk.
Ultimately it is down to you as an individual to choose what level of risk is acceptable. It may be that having weighed up the risks – both unavoidable and avoidable - you decide Direct Lending simply isn’t for you. However, if you understand and are happy with the level of risk then, with significantly higher returns than can currently be found in a traditional high street savings account, Direct Lending and P2P lending can be a great way to make your money work harder.
*Warning: nothing in this article should be construed as advice. Your capital is at risk.
To find out more about how to make informed decisions about your lending portfolio, download your free copy of Steps to Successful Investing in Direct Lending.