Saturday, June 17, 2006

Effort, risk and return

I was trawling through the most recent entries on pfblogs when I came across this post by Makingourway asking whether putting US$80,000 into 200 small loans through Prosper was worth the time and the risk involved. I have submitted a comment but after thinking about it some more, I felt that it was an interesting question and wanted to explore the questions raised in more detail.

The first question is effectively whether earning an additional return on investment is worth the time spent. This is probably the easier question to answer although different people may well come up with different answers. A person with a demanding job, children and a range of other interests, some of which could suffer as a result of the time spent managing the loan portfolio, may conclude that the additional return did not justify the time spent. In contrast a person who is not in full time employment and has enough spare time may reach the opposite conclusion - that they have plenty of time to spare and that administering a loan portfolio is a good use of some of their time. Personal financial circumstances may also affect the decision as well - a person who is struggling to put aside enough for retirement may reach a different conclusion than a person who is less worried about retirement. Put differently, what is the value of your time and the opportunity cost?

The second question is a much harder one: does the additional expected return justify the additional risk that is being assumed. With 200 Prosper loans outstanding, the probability of one or more defaults occuring in a given year has to be quite high (how high?) even if borrowers with better credit ratings are targetted. The question reminded me very much of the academic studies on junk bonds that were done in the 1980s. If I recall correctly, at least some of the studies concluded that a well diversified portfolio of junk bonds could be expected to provide a risk adjusted return that was higher than the risk free rate of return (usually using Treasury securities as a proxy for the risk free rate of return). If you are borrowing to invest in the loan portfolio the number crunching would be different than if you are investing money that would otherwise be put on deposit.

Assuming my memory is correct, does the analogy hold good for a portfolio of loans made through Prosper?

No comments: