Why is diversification important in P2P financing?
Diversifying your investments across multiple notes is one way to increase the success of your investments on P2P financing platforms. While some investors already know the basic concept of diversification, which is generally not to put all your eggs in one basket, there are other investors who might still not understand the importance and impact of diversification in P2P financing.
Investors may lose their entire principal amount
P2P financing generally has a capped interest rate for its investors. The maximum interest allowed in P2P financing is 18% p.a. In a best-case scenario, you will enjoy a return capped at 18% p.a. However, in the worst-case scenario, you could also lose 100% or your entire principal amount.
To understand the concept more clearly, please refer to our illustrations below on the different approaches taken by Investor A and Investor B on their investment of RM10,000 each onto a P2P financing platform.
Investor A – High Concentration Approach
Investor A invests RM10,000 into a single note with an interest rate of 10% p.a. for a period of 12 months. Investor A may expect to earn RM1,000 in interest for this note, however, this may not necessarily be the case.
We list down below, the possible outcomes of this investment for Investor A:
Outcome 1: If the Issuer pays back promptly
If the note has not defaulted, the outcome of the investment for Investor A will be:
Principal Received: RM10,000
Interest Received: RM1,000
Rate of Returns on Investment: 10%
Outcome 2: If the Issuer defaults on the 7th month
If the note defaults on the 7th months, the outcome of the investment for Investor A will be:
Principal Received: RM5,000
Interest Received: RM500
Rate of Returns on Investment: -45%
Outcome 3: If the Issuer defaults on the 1st month
If the note has defaulted with no repayment, the outcome of the investment for Investor A will be:
Principal Received: RM0
Interest Received: RM0
Rate of Returns on Investment: -100%
Investor B – Diversification Approach
Instead of investing in a single note, Investor B splits his investment amount of RM 10,000 into 100 notes of unique companies worth RM100 on each investment. If the average tenure of a note is 12 months and the average interest rate of each note is 10% p.a., Investor B may expect to earn an estimated cumulative sum of RM1,000 in interest for all the invested notes.
A 2% default rate across a diversified portfolio of 100 notes of unique companies and given that 2 out of 100 unique companies (2% default rate) defaulted, Investor B is estimated to lose RM200. In this instance, the estimated rate of return on investment for Investor B will be 7.8%
By comparing the 2 approaches taken by Investor A and Investor B, a more consistent return is possible for Investor B due to lower concentration risk. The diversified approach adopted by Investor B is also suitable for a long term investment in P2P financing due to controlled concentration risk.
A diversified portfolio may provide high consistency in returns
The above chart shows that the higher the number of unique SMEs that an investor has invested in, the more consistent the annualised net returns will be. However, it should be highlighted that diversification here does not eliminate or remove all risk in respect of investment.
Some may assume that the chances of experiencing a default on a single note are low. This is not necessarily true. Therefore, Funding Societies highly recommends its investors to diversify their investment portfolios across as many notes as possible.
Disclaimer: The information above is meant purely for informational purposes only and should not be relied upon as financial advice. Users may wish to consult a financial advisor before making any decision to invest in any investment product.
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