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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Introduction

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 the 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!

But many people are skeptical of such investment 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 skepticism 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. But of course, there’re 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, 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 always be minimising risk to an acceptable level while maximising your returns.

Getting back on topic, let’s discover the most effective way 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 everyone knows. Perhaps, even elementary school kids would be able to explain in layman’s terms.

Investors always use diversification to reduce concentration risk in their investment portfolios. That helps 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 perfectly by spreading their investments across different borrowers.

But 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. But investors should also diversify by investing in borrowers that operate in different industries with low correlation.

It simply means that if you’re investing in two borrowers with similar creditworthiness, the two borrowers shall be operating in different industries.

Why is it a big deal?

When there’s any catastrophe or political changes that might adversely affect a specific industry, your risk of investment would be much lower.

Imagine you’ve 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 operates in the entertainment industry instead. The more uncorrelated your borrowers are, the lower the risk by using diversification.

Just giving you another example, diversification may not be effective if two borrowers operate in airline and transportation industries respectively if there’s a 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 should ask yourself before investing in P2P lending.

The effectiveness of a diversification strategy also depends on the allocation of your money available for investment. It’s clearly not rocket science and applies only mathematics. Imagine now you’ve 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 a 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 a 4% default rate

Let’s use Funding Societies as the benchmark as the Company had successfully raised more than RM1 billion 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 may not be recoverable on day 1. It still provides a higher return than the traditional investments like fixed deposits. That means you don’t have to worry that the borrowers might not repay the loans.

Of course, historical data doesn’t guarantee the exact outcome of the future. But it’s very easy for you to re-adjust your loan portfolios with the appropriate allocation from time to time.  Besides, the default rate is unlikely to swing to different extreme ends since the P2P lending platforms apply their credit risk assessments consistently. And the borrowers’ credit profiles are also unlikely to differ significantly over time.

#3 – Diversify your investment in different P2P lending platforms

Next, you 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 are different.

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 a 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.

Personally, I’ve been investing in P2P lending via Funding Societies for quite some time. Among other reasons, Funding Societies is the largest platform and has the highest investment opportunities. That’s the most important factor for me. Because you can’t diversify if there aren’t enough investment notes for you to invest.

You can refer to this article for a step-by-step guide to invest in Funding Societies. (Read Funding Societies Malaysia Review – Best P2P Lending Platform in Malaysia.) It also includes FREE useful tips on factors to consider when you’re selecting an investment note before investing.

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. This 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. But each investor may have different risk appetite. Therefore it’s a better idea to carry out your own due diligence.

There are certain metrics that would help 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.

The industry of the borrower – Certain industries tend to be riskier than others at different times. For example, the construction industry has a negative outlook following the cancellation of mega infrastructure projects and a reduction in infrastructure spending by the Government… Similarly, the 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 indicates the borrowers’ creditworthiness as well.

Final Thoughts

The emergence of P2P lending appears to be the “newfangled” investment in Malaysia. But 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 a 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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