2 Rules To Lend Easily And Be Safe From Recessions

Today I want to look at how to prevent permanent lending losses caused by such things as recessions.

4thWay often alerts its subscribers in its newsletter if there are signs that a P2P lending website is lowering its standards, e.g. by accepting more borrowers with worse financial records.

If those changes in standards ever get severe enough to cause losses at some P2P lending websites, I think the cause of it is usually going to be because we're in a P2P lending bubble, and lenders and P2P sites didn't take care.

Regardless of what the investment is, all investors suffer from bubbles bursting if they're not prepared for them, and that often happens when a recession comes. We can be sure that P2P lending won't be any different and so the unprepared will experience some tough times.

That said, it's considerably easier to protect yourself from these situations in money lending than in the stock market.

Two techniques to defend ourselves from recessions

The way to avoid losses in those instances are different to avoiding bubbles by being alert. But it is still blessedly simple.

I am very confident these two techniques will help protect lenders like you and me from such downturns:

• Spread your money widely across P2P lending websites that have different kinds of loans, ensuring you include some low risk and balanced risk lending accounts.
• Keep lending and re-lending regularly.

My confidence in these methods is based on both experience in other investments, tough, bank-style stress tests on the P2P lending companies' existing loan books, and 17 years of P2P lending results.

Let's look at experience in other investments first.

What we've learned from other investments

There are piles of research papers about the benefits of spreading your money widely and investing regularly in the stock market.

Most studies vastly understate the risk of losses, because the methods used in the research are just too flawed.

I don't think that applies to the work of Professors Elroy Dimson, Paul Marsh, Mike Staunton of London Business School, which is 4thWay's go-to reference for share and bond research. They do the best research that I know, by a very long margin, on long-term investment returns.

They wrote the book “Triumph of the Optimists: 101 Years of Global Investment Returns” and produce an annual report on investment returns for Credit Suisse.

The professors have shown that the chances of losing money by putting a one-off sum of money into shares listed on a single stock market (such as the London Stock exchange) are surprisingly high.

Put money into the UK stock market on one day only and, 20 years from now, you have maybe a one in four chance of having less money than today, when you adjust for inflation!

(You have a considerably higher chance of being even poorer if you stick to using savings accounts or bonds, however.)

That's despite the fact that investing for longer is supposed to be lower risk, especially in something as volatile as the stock market. Only recently, the broadly quoted guidance has gone from recommending a minimum five years investing in the stock market to minimum ten years. Clearly, that's still taking chances.

How stock-market investors reduce their risks

Thankfully, stock-market investors have two ways to massively reduce their chances of such a disaster:

• Spread your money even more widely – so across eight or so stock markets, not just the UK stock market.
• Invest every month, not just once.

By spreading your money across more stock markets, you reduce the risk of having all your money, unluckily, in a market that does badly over two decades.

By investing regularly, it means that you buy fewer shares when prices are high (i.e. when they are more expensive and therefore more risky) and you buy more shares when prices are low (i.e. cheaper and less risky).

So it's okay if you buy some shares at the top of a bubble, because you're buying even more shares, more cheaply, when the bubble bursts.

Loans are priced differently to shares of course, but the up and down movements are the same.

Tough stress tests

So experience in other investments shows that spreading money widely and investing regularly is a great defence against disasters, seriously lowering your risks.

But let's not just rely on a comparison to other investments to test these two techniques.

It's also sensible to assume some very bad scenarios to see if you might lose money on your loans, and how much, when bad-debt rates shoot for the sky due to recessions and property crashes. These are called “stress tests”.

Severe stress tests are built into the 4thWay PLUS Ratings using a much stricter version of the Basel stress tests that global banks are required to do. These tests were built by credit specialists, a credit-risk and Basel specialist, and experienced investors. You can see those ratings in our comparison tables on those P2P lending websites for which we have completed an assessment.*

If you conduct your own tests, and make them as severe as you need for your own requirements and peace of mind, you'll hopefully find similar results.

Two recessions later, actual results in P2P lending have held up incredibly well

The industry has now gone through the Great Recession of 2008/9 (albeit just one P2P lending company existed then) and then the pandemic recession, which was the worst dip in over 300 years. Each time, the industry continued to provide stably profitable returns, even as stock markets collapsed.

The bottom line is that the vast majority of lenders who have spread their money across lots of loans can currently expect to come out with zero losses at the height of a disaster.

Modest losses can be acceptable in a dreadful recession

It would not be terrible to suffer modest losses in an extraordinarily bad period that's worse than what we've already experienced in the past couple of decades. You just have to be confident of recovering to a positive gain again in the following years.

Yet our stress tests are severe, and plenty of P2P lending companies still pass with flying colours, meaning you can only really expect a minority of lenders using sensible strategies to lose money, even in such horrifically bad circumstances.

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