18th October 2016
Previously in our blog series we’ve discussed the concept of diversification, and how investing across a varied range of sectors, and types of investments can minimise your exposure to losses. Today let’s explore the concept of risk and rewards in peer to peer lending.
Are you the kind of person that enjoys taking risks? Would you try a bungee jump without hesitation? Or does the very idea of it turn your stomach? Ultimately, we all have different attitudes to risk and before you start to invest – it’s important to establish how you feel about taking risks when it comes to your finances.
If the idea of losing just a few pounds makes you start to sweat – you’re probably a more risk averse person. This means that you should select a range of investments with a lower risk profile such as traditional savings, bonds or low-risk P2P investments i.e. smaller loans, repaid over a shorter time.
If you are more open to the idea of taking some losses, and are generally more open to longer term investing – where you might ride out the peaks and troughs of an investment to potentially get a higher return – then you may be less risk averse. You might consider investing in stocks and shares, or higher risk profile P2P investments which might potentially be larger loan amounts.
Whatever you decide your preferred risk profile is, it’s important to remember that your capital is always at risk. If you are unsure you should consult a Financial Adviser.
Risk is defined as the chance that an investment’s actual return will be different than expected. This includes the possibility of losing some or all of the original investment.
This graphic visualizes the relationship between risk and reward:
Essentially, when it comes to investing your money it’s generally accepted that the higher the level of risk you take in losing your capital, the higher the potential returns are. Conversely, the lower the level of risk you take – the lower the potential returns are.
So as an investor how do you make a risk assessment when deciding where to place your investments? Let’s take at what you should think about before investing:
Each P2P lender will have their own expected default rate – when lending there is always the risk that a borrower will default.
A default is when the borrower breaches the conditions of agreement of the loan – this can include failure to make payments on time. The impact of such defaults is usually minimized by provisions that peer to peer lenders make. For example, at Huddle we ring-fence investor funds to ensure that lenders can be repaid and aren’t left out of pocket in the unlikely event that this happens. Before you begin to invest inspect the expected default rate of your P2P investment site.
If you would prefer to make investments where you know about the borrowers, rather than letting the P2P platform make the investments on your behalf these are the considerations you should make when assessing risk:
Who are the people you are lending to? What is their history?
Do you know much about their business history? Do they have a suitable background in their industry?
Does the loan purpose sit in line with the business goals? For example, a restaurant looking to invest in new cooking equipment makes sense,
The more that a business is requesting to borrow – the bigger the risk. The amount also has to be compared against the wealth of the business.
How long is the borrower wanting to repay you for? If they are paying back the loan a little each month and fully repaying you within a few years, that’s less risky than over the course of 5 to 10 years.
If the business has buildings or other assets that can act as insurance on the loan that reduces the level of risk attached to them. If they default then the assets can be sold to repay the loan.
In summary, before you begin to invest you should follow these steps:
At Huddle, we aim to provide unbiased and informative content to educate you on every aspect of the peer to peer lending market so you can stay informed and easily understand how every element of it works.
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