Great Tips to Reduce Risk of Investing in P2P Lending

Best Way to Avoid Risk of Investing in P2P Lending Malaysia

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Preface

In recent years, P2P lending has gained traction in Malaysia. Many investors have jumped on the bandwagon to join the craze without understanding the risk of investing in P2P lending. What are the investment options available in Malaysia that could yield at least 10% return per annum? Probably there are but most require sophisticated investment knowledge like investing in stock market. It could easily burn a hole in the mom-and-pop investors’ pocket. That explains why it’s difficult to resist the impulse to react towards such lucrative returns from investing in P2P lending. Not to also mention that the entry requirement to invest in P2P lending is as low as only RM100 in Malaysia!

Nonetheless, many people are sceptical of such investment offering that sounds too good to be true. It doesn’t come as a surprise to me. Many people are still unfamiliar with P2P lending given that it’s still relatively new in Malaysia. Refer Peer-to-Peer Lending in Malaysia – Quick Guide for better understanding on P2P lending in Malaysia. Remember the first time when I spoke to my auditor colleagues about P2P lending. The auditors’ professional scepticism starts kicking in when they heard about it and everyone threw me the same questions.

Is P2P lending legal in Malaysia?

Malaysia became the first country in ASEAN to regulate P2P lending after Securities Commission Malaysia (SC) introduced a regulatory framework for P2P lending operators in 2016. To date, there are only six licensed P2P lending operators in Malaysia.

Is it safe to invest in P2P Lending?

Certainly there’s always risk associated with every investment. You can refer Understand the Risks of Investing in P2P Lending for better understanding on the underlying risks of investing in P2P lending. However, there are ways to reduce the risk of investing in P2P lending which is the topic of the day.

How to Reduce Your Risk of Investing in P2P Lending?

You may hesitate whether to risk your money in P2P lending or not knowing that you could get nothing back. Don’t chicken out yet! There’s always a trade off between risk and return. Higher returns come with higher risk. A savvy investor always allocates resources to its best efficient use to maximise returns. Your goal should be minimising risk to an acceptable level depending on your risk preference while maximising your portfolio returns. Getting back on topic, let’s discover some effective ways to reduce your risk of investing in P2P lending.

Diversification

“Don’t put all eggs in one basket”. It’s indeed a common investment philosophy that’s widely accepted by the community. Perhaps, even elementary school kids would be able to explain in layman’s terms. Oftentimes, investors use diversification to reduce concentration risk in their investment portfolios. That helps to avoid the risk of losing all money in a particular investment when the investment fails. Many P2P lending investors think that they have diversified their loans portfolio impeccably by spreading their investments across different borrowers. However, they fail to understand that diversification is far more than just investing money in different investment notes.

“Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others which they know nothing about” – Philip Fisher

Diversification involves different strategies and is a state-of-art skill that investors should not take it so lightly.

#1 – Diversify by investing in investment notes with low correlation

No doubt the simplest way of diversifying in P2P lending is to spread your investment across different borrowers. However, investors should also diversify by investing in borrowers that operate in different types of industries with low correlation. It simply means that investing in two borrowers with similar creditworthiness operating in different industries is far more effective than both borrowers operating within the same industry.

Why is it a big deal? Imagine you have now invested in two investment notes where both borrowers are construction companies. Your risk exposure is much higher when the Government announced the cancellation of mega infrastructure projects which may have a direct link to both of your borrowers. On the contrary, the risk would be minimised if one of the borrowers involves in the entertainment industry instead. The more uncorrelated your borrowers are, the risk is lower by using diversification. To put this into perspective, diversification may not be effective if two borrowers operate in airline and transportation industries respectively in the event of sudden spike in global oil price.

#2 – Diversify by allocating the optimal amount to invest

“How many tranches should I split my investment into?” “How much should I invest in each investment note?” These are the questions that you need to ask yourself before investing in P2P lending. The effectiveness of a diversification strategy also depends on the allocation of amount available for investment. It applies mathematics and clearly not rocket science for you. Imagine now you have RM10,000 to invest in P2P lending. Let’s break it down into 50 tranches with each tranche worth RM200. Each tranche represents 2% of the total investment (200/10,000).

Scenario 1 with 2% default rate

Calculation of investment in P2P lending with 2% default rate
Scenario 1: Investment in P2P lending with 2% default rate

Scenario 2: Investment in P2P lending with 4% default rate

Scenario 2: Calculation of investment in P2P lending with 4% default rate
Scenario 2: Investment in P2P lending with 4% default rate

Let’s use Funding Societies as the benchmark as the Company had successfully raised more than $700 million across the region with the largest market share in Malaysia. Funding Societies has maintained a default rate of less than 1.5% to date since its incorporation across the region. Both scenarios above with default rates of 2% and 4% respectively exceed the Funding Societies historical default rate. Magically they still provide attractive gross returns of 7.8% and 5.6% respectively! The net return after service fee would certainly still be much higher taking into account the effective interest if you reinvest the amounts received throughout the year.

What does that mean? It’s perfectly fine even if there’s a default!

There are expectations that some loans are not recoverable on day 1. It still provides a higher return than the traditional investments like fixed deposits. That means you do not need to fear of borrowers not repaying the loans. It may be arguable that there may not be sufficient data to establish a historical collection trend given that P2P lending is still at its infancy in Malaysia. However, it’s rather easy for the investors to re-adjust their loan portfolios with the appropriate allocation of amount from time to time. The past performance may not be indicative of future results. Nonetheless the historical default rate serves as a good proxy for investors to diversify their investments. The default rate is unlikely to swing to different extreme ends as the P2P lending platforms apply consistent credit risk assessment and the borrowers’ credit profile is unlikely to differ significantly over time.

#3 – Diversify your investment in different P2P lending platforms

Moreover, investors should also diversify by investing in different P2P lending platforms. Although the obligations of P2P lending operators and the platform rules are broadly similar, the credit assessment methodologies may differ. For example, Funding Societies provides an opinion-based assessment and provides qualitative disclosures to the investors. On the contrary, most of the P2P lending platforms assign a risk grading to each investment note based on their respective credit assessment.

Each P2P lending platform may have different level of risk tolerance. For instance, QuicKash offers investment notes that come with a principal guaranteed element but a lower interest rate as compared to other P2P lending platforms. It charges the borrowers a guarantee fee for 3rd party guarantee services. Some investors may favor such offering as it reduces the risk of default by the borrowers. Therefore, it’s important to understand the characteristics of each P2P lending platform before you diversify your investment. You can refer here for a complete review and comparison of P2P lending platforms in Malaysia.

Do Your Own Due Diligence

Based on SC requirements, each P2P lending platform is obliged to verify the relevant information or documents submitted by the borrowers. These information is made available to all investors through the platform. More often than not, investors will rely on the P2P lending operators’ credit assessment of each borrower. Nonetheless, each investor has different risk appetite therefore it’s a better idea to carry out your own due diligence. There are certain metrics that would ease you to decide on which investment note to invest.

• Loan tenure – A loan with longer tenure poses higher uncertainty as compared to a shorter one.

Historical financial information – Some of the P2P lending platforms disclose the audited financial information of the borrowers. A business that is consistently making losses based on historical trend has a higher risk of default.

Age of the borrower – A new business has a higher risk of default as compared to long established businesses.

Industry of the borrower – Certain industries tend to be riskier than others at different times. For example, construction industry has a negative outlook in conjunction with the cancellation of mega infrastructure projects and reduction in infrastructure spending by the Government to reduce fiscal debt. Similarly, plantation industry may pose a higher risk due to low palm oil price as a result of global oversupply.

Repayment history – Some borrowers are recurring customers of the P2P lending platforms. The repayment history of the borrowers serves as a good measure of the borrowers’ creditworthiness as well.

Final Thoughts

The emergence of P2P lending appears to be the “newfangled” investment in Malaysia. However, It’s rather important for investors to understand the risks of investing in P2P lending before getting started. There’s no harm getting superfluous information rather than having limited understanding before you invest especially for those who can get hot under the collar easily. If you have already started or getting ready to invest in P2P lending, GOOD LUCK!

 

 

 

 

 

 

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  1. Pingback: A Complete Review of P2P Lending Platforms in Malaysia

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