In 2007 I started investing with Prosper.com. Prosper is a peer to peer lending website. I thought I was investing cautiously, only choosing to loan to people with good or very good credit (A & AA). Boy was I wrong. I learned some valuable lessons about risk and predicting the future.
With Prosper, like all my investments, I moved slowly. I researched peer to peer lending and Prosper. I examined the risks of peer to peer lending. As you can see, I did my homework. However, I underestimated the true risk.
I funded 10 loans with the minimum $50 each. Of those 2 were AA and the rest were A. The highest and second highest credit rating on the site. Typically a credit rating relates to the probability that the loan will be repaid.
I lent conservatively. I wanted to test the waters before I plunged in. It's a good thing I did.
Of the 10 loans I funded 3 charged off. That means the borrower has stopped paying and there is little chance for recovery of the balance. I lost $112.02 on charge offs. Two loans are passed due. Two are paid in full and Three are still paying.
As you can see this is a terrible result. Most (all) banks would be out of business if they had returns like this.
In total I've lost $61.37 as of the time of this post. Not terrible, the stock market is worse, but remember, I lent to the highest credit grade.
Prosper constructed a very poor model of risk. If 3 out of 10 of A/AA loans charge off, then what happens to the really bad credit ratings?
Credit Industry In General
What does this tell us about the credit industry in general? From the recent finanical crisis, we can see that the credit industry is not good at predicting risk. We could probably say that humans in general are not very good at predicting risk in complex situations.
My experience on Prosper just made this more personal, it brought home the point. I'm not very good at predicting risks. That's why I keep a substantial portion of my wealth in FDIC insured deposits.
The world is way too unpredictable. Our models of risk are very often flawed.
So What Do We Do?
Knowing this, what can we do to about it? Well here are a few tips:
- Don't keep your 401(K) money in your company stock
- Self Insure – keep a large amount of cash in the bank
- Buy as much Insurance as you can – Life, Health, Auto, Liability (Umbrella), etc
- Assume the worst from your investments
Knowing that we don't know about risk is a start. I'm trying to educate myself about risk. Here is a list of books that I'm reading or have read about risk:
- Fooled by Randomness: The Hidden Role of Chance in the Markets and Life – Nassim Nicholas Taleb
- The Black Swan: The Impact of the Highly Improbable - Nassim Nicholas Taleb
- Traders, Guns & Money: Knowns and unknowns in the dazzling world of derivatives - Satyajit Das
- The Misbehavior of Markets: A Fractal View of Financial Turbulence - Benoit Mandelbrot
- Capital Ideas Evolving - Peter L. Bernstein
- Against the Gods: The Remarkable Story of Risk - Peter L. Bernstein
Related Posts
- Why A Mortgage Increases Your Risk
- Moving My Money Away From Prosper
- Flood Insurance For Renters
- Do I Need Flood Insurance?
- The Real Reason I Paid Off My Mortgage