A few nights ago, I woke up in a cold sweat at 3:45am.
I tried thinking happy thoughts…
I tried breathing deeply…
I even tried switching pillows.
But it was no use: I couldn’t get back to sleep.
The fact is, I was rattled about a series of recent investments I’d made.
I’m not proud of being rattled. Normally, I wouldn’t even mention it.
But it happens to everybody:
And just about every professional and individual investor in the market.
So let me tell you what I was so worried about –
Then I’ll tell you what calmed me down.
Maybe it’ll help you sleep better one night in the future.
Right before the winter holidays, there were two blockbuster IPOs:
LendingClub (NYSE:LC) and OnDeck (NYSE:ONDK).
These two companies, and dozens of others like them, are aiming to disrupt the $3.2 trillion lending industry.
They’re “Alternative Lending” companies. They pool capital from investors like us, then lend it out to consumers or small businesses.
By cutting out traditional banks as the middleman, borrowers pay less, and lenders like us can earn significant returns.
LendingClub turned into the biggest U.S. IPO of the year. It raised $1 billion.
A few days later, riding the momentum, OnDeck blasted onto the public markets as well.
Investors made a fortune – early angels, venture investors, even public market investors.
Equally as important, the IPOs gave a boost of credibility to the alternative lending sector.
So Why Was I Losing Sleep?
I’ve been investing on various lending platforms for more than a year…
And I’ve been earning yields approaching 10%.
But even with market-beating returns and the validation of successful IPOs, alternative lending is still a young industry.
It hasn’t gone through a serious bear market, or a major economic downturn.
What if some worst-case scenarios actually happened?
Would all those loans “go bad,” leaving lenders with pennies on their dollars?
I’m not much for milk and cookies or old movies when I can’t sleep.
Instead, when I’m really worrying about something, I sit at the kitchen table, turn on the computer, and start looking for answers.
On this particular night of insomnia, it took just 7 minutes to hit pay dirt:
As it turns out, a highly credible alternative lender called Funding Circle had recently run an experiment:
They ran a “stress test” to see what might happen to investor returns during an extreme economic downturn.
Basically, a stress test shows how the future might look if things go terribly wrong. It’s a way to analyze the results of unfavorable scenarios –
From huge increases in unemployment and interest rates, to disastrous decreases in factors such as wages and GDP.
To run the test, Funding Circle hired an independent consulting firm: Hymans Robertson, a UK-based company with expertise in this area.
In a stress test mimicking an extreme economic downturn, Hymans found that Funding Circle’s bad debt rates would rise more than 50% from their current levels.
At first blush, that sounds horrible –
But in fact, a 50% increase translates to bad loans going from 2.2% of the total pool, to just 3.4%.
So instead of earning annualized net returns of 6.7% over a three-year “stressed” economic period, investors would earn 5.6% instead.
Armageddon never looked so good.
But It’s Just a Model
It’s important to note that this is just a financial model – it’s an estimate of what something might look like in the future.
To put this in perspective, keep in mind that a similar type of model was used by the brilliant Nobel laureates of Long-Term Capital Management in the 1990s.
Their model worked perfectly for several years – until it didn’t work at all:
In the span of four months, they lost $4.6 billion.
Because a “black swan” occurred – in other words, a series of events that were outside of normal expectations, events that couldn’t have been predicted.
Stress-Free Investing (In Three Simple Steps)
We remain enthusiastic about the business prospects for the alternative lenders, and we’re bullish on the financial prospects for investors who lend.
But just in case you invest, and then some unimaginable black swan occurs, here are three easy ways to protect yourself:
Asset Allocation – Despite the lofty yields, only invest a small amount of your assets into alternative lending.
Invest in Many Loans – LendingClub, for example, has published results showing that 99% of investors had positive returns if they held more than 100 loans.
Sleep Like a Baby
After reading the results of the stress test and reminding myself that I’d already taken the three safety precautions I prescribe to all, I went back to bed…
And guess what:
I slept like a baby.
If you follow these basics, you should sleep like a baby, too.
(Please note: Crowdability has no financial relationship with any of the lending platform mentioned above. We’re an independent provider of education, information and research on start-ups and alternative investments. That being said, Matt continues to be a lender on these platforms.)