Last night I listened in on an online discussion with Scott Langmack, a veteran Lending Club investor who has averaged 12.6% returns over the last couple of years. During the seminar, Langmack shared tips for “beating the average” with Lending Club. What follows is a rundown of Langmack’s four keys to maximizing returns.
1. Diversification is essential
Langmack argued that, in order to achieve maximal stability, you need to hold upwards of 400 notes in your portfolio. Assuming you invest the minimum of $25/note, that works out to $10k. That’s a pretty tall order for a lot of people, and it can be time consuming to assemble a portfolio of that size.
The good news is that he’s not saying that you shouldn’t invest with less. Rather, he’s saying that the fewer notes that you have, the less predictable your returns will be. At the 400 note level, the law of large numbers takes over, and your returns become much more predictable.
In other words, if there’s an expected default rate of (say) 5% for a certain credit grade, you can be fairly certain that you’ll get somewhere in the neighborhood of 20 defaults if you buy 400 notes. If you buy just 10 notes, however, it’s quite possible that you’ll get unlucky and wind up with 2-3 defaults.
While 2-3 defaults might not sound like a lot, that works out to a default rate of 20-30%, way above the 5% expectation. Then again, you might get lucky and have zero defaults, putting you ahead of the game.
2. Select for job stability
I have to admit that this is something that I haven’t paid a lot of attention to, but Langmack’s argument makes great sense. When selecting notes, don’t just look at how much money someone makes. Take a look at what the person does for a living, and how long they’ve been doing it.
If your prospective borrower is a relative newcomer in the retail sector, you might want to tread lightly. Given the current state of the economy, it’s not hard to imagine someone in that position losing their job. In contrast, government employees with a decade of experience are much less likely to experience a bout of unemployment.
3. Select the loan type
When loans are listed on Lending Club, the borrower has to tell you why they’re borrowing. The problem with this model is that you’re relying on the borrower’s honesty. I was thus surprised to learn that the reason for borrowing is actually predictive of default rates.
At the top of the heap are loans to cover vacations or weddings, or to refinance credit card debt to a lower rate. Such loans have an average default rate of 2%.
Next up are loans to cover a car or other major purchase, medical costs, home improvements, or moving expenses. Such loans have an average default rate of 3.5%.
Finally, we have loans for debt consolidation, educational expenses, house down payments, or for business ventures. Such loans have an average default rate of 5%.
Of course, there are some grey areas here… How do you distinguish between someone refinancing credit card debt vs. someone consolidating their debts? While the former is arguably a positive money move, the latter might be that last act of a desperate debtor. Unfortunately, distinguishing between the two can be a bit of a judgment call.
4. Select your rate and expected returns
The last step is to determine what sort of return you’re looking for, as well as how much risk you can stomach. At the low end, Langmack says you can get 7-8% returns with “very low volatility” and “very low risk” by investing in high grade loans. I think the true amount of risk remains to be seen, but the historical repayment rates seem to support his view.
Langmack is looking for higher than average returns — in the neighborhood of 12% — so he targets loans that are paying somewhere in the 12.5% to 20% range. In other words, he skips over Grade A and Grade B loans and heads straight for riskier notes. As noted above, by choosing his loans carefully and minimizing defaults, this strategy has resulted in a 12.6% annual return.
My personal experience
Since I used “Lending Match” to automatically select my original portfolios, I didn’t really look at pay any attention to individual loans. Now that one of the loans in my “High Risk” portfolio is overdue, however, I can look back with 20/20 hindsight.
For starters, here is the original (unedited) description of what the loan was for:
Repayment to family members. Sudden Death of Mom (repayment of expenses)
Reatin Legal help. (Laywer)
I’m not sure about you, but I wouldn’t have funded this loan if I had looked at it closely. The borrower actually looked quite good in terms of job stability — 14 years with a major airline, and an annual income of $75k, but…
My biggest concern with this loan request (aside from the poor grammar) is that this person appears to have problems on multiple fronts. Not only are they looking to consolidate debt (one of Langmack’s red flags), but they also need an attorney for some unspecified reason. Yikes.
The good news is that this is just one of the 78 (and counting) notes that I currently hold, so it’s not a big hit. Moreover, in the time since I made my initial investments, I’ve made a point of reviewing loan requests more carefully. Hopefully this will further reduce the risk of defaults and keep my Lending Club returns nice and high.