Don’t put all your eggs in one basket

If you want to protect yourself when investing then one of the most important things to do is to make sure that your risk is spread – as the old saying goes: don’t keep all your eggs in one basket.

Why? Consider stocks and shares. If you’ve picked a winner, you might do very well out of it, but if you were unlucky enough to pick a bad company, you could lose your entire investment. Other financial investments are no different.

Peer-to- peer or marketplace lending platforms link investors directly with borrowers. There are different models, but the thing that they have in common is that they facilitate investment into loans– that is, you stand to earn a good return if the borrower repays the loan in full and on time, but you could make a loss if not.

Diversification in peer-to- peer lending

One approach to manage these risks is to diversify and lend to many different borrowers. In doing so, you spread the risk: if you lend to, say, 1,000 borrowers in very small chunks, then even if 20 of them don’t repay in full, you’d still expect to earn a good return since 980 of them are repaying in full.

Happily, the best platforms make it as easy to diversify. Some do this by allowing you to automatically split your money across loans, and others do this through a mechanism called a Provision Fund.

A Provision Fund is a central pot of money made up of risk-weighted fees on each loan, which reimburses investors if a borrower fails to make a payment. That protects investors from individual defaults, since as long as the Provision Fund has sufficient money in it, investors will not make a loss even if a borrower misses a payment.

What if borrowers are connected?

Another way you can diversify is by lending to different types of borrowers. Most platforms lend only to one type of borrower – UK businesses, for example. That provides some diversification – you can lend to thousands of different UK small businesses – but if something happens that affects all these businesses, you could still have more exposure than you might like.

By contrast, RateSetter lends to a range of borrowers: 65% of its current lending is to individuals, 24% is to businesses and 11% is to property developers. In this way, there is extra diversification: investors’ money is not tied to any one borrower type. Another way of achieving this sort of diversification might be for an individual investor to lend through several platforms that specialise in different borrower types. Of course, no single product or even asset class can provide perfect diversification. However, used well, peer-to- peer lending can be an excellent way to spread your risk and minimise your exposure to any one asset.

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