Prosper Lending

I have been involved with peer to peer lending site Prosper for almost a year and a half. I decided to try it out as further diversification of my portfolio and because I thought the idea was interesting. For those who don't know, Prosper allows peer to peer loans to be made. Basically borrowers apply for a loan, and many lenders bid on the interest rate with a small piece of the loan. For the lenders, the rates are higher than you could get with a CD or money market, but for the borrowers lower than most credit card rates, usually in the range of 7-25%. However, with the higher interest rates come the risk of default. Typically, a lender would own many loans in the range of $25-$50 spread across a diverse set of credit ratings.

Not surprisingly, this interest rate mostly attracts borrowers who couldn't get a home equity or lower interest loan, so you know immediately these are rather risky loans. Doing a quick look at the lendingstats.com you can find a lot of statistics on current lenders. The average return on investment (ROI) for lenders with loans of >6 months is shown in the graph below:

I started with a pretty diversified investment of $3,187. Over the last year and half, I 've seen two loans default, two get paid off early, and the rest are current.

One problem with Prosper is I can’t really trust the ratings and there is a very high default rate. Virtually everyone has experienced at least one default who has loaned any sizable amount of money. The current Prosper history of all loans is shown below.

Note that 10.2% of all loans are currently 3+ months late or defaulted. Typically 3+ month late loans don't become current. Then the loans that are in really good shape, end up paying off their loan early. So you don’t make much interest off of the good loans, and you are stuck with a number of risky loans that may default. Just one or two defaults can seriously eat into your profits for the year. Last year I had about $2900 invested and ended up with net profits of $19, while my current ROI is estimated to be 7.18% for the life of the loan. Plenty of A rated loans default as well. See from my loan breakdown below that I had a diversified collection. An A and C rated loan defaulted, while a AA and D loan were paid early.

Finally, perhaps the biggest problem is there is no liquidity. There currently is no secondary market, so your money is tied up until the loan is paid off in a maximum of three years. I would consider investing on a continuous basis if I was able to pull it out when I needed. Here are a few things I've learned and suggest:

1. Don't setup any automated investing through Prosper, you can use filters, but in the end you need to do a little investigating before pulling the trigger,
2. Don't invest in any businesses: Most businesses go bankrupt and there is very little damage to the individual's credit (or motivation to pay off the loan) if they had it setup as an LLC.,
3. Fund only smaller loans, <$3,000, as there is less chance of them falling behind.
4. Research online using LendingStats and the message boards at Prospers.org.
   
   

ETFs vs. Mutual Funds

Quick list in the difference between Exchange Traded Funds (ETFs) and Mutual Funds. If you listen to talk radio financial advice, you may have come across Ric Edelman, financial planner extraordinaire, who loves to bash mutual funds (since his last book came out). He, besides endlessly promoting himself, pushes ETFs instead. However, he is making an apples to oranges comparison. His main problem with mutual funds are with actively managed funds, while ETFs are index based funds, so it is more proper to compare ETFs to index mutual funds. So if you believe in the philosophy of investing for the long term by indexing, I think both options are equally good. Main differences:

• ETFs are traded throughout the day on the stock market, Mutual Funds are only bought at the close of the market. For the long term, this is not a major issue, as you can more precisely buy and sell and ETF using limit or stop orders, however with mutual funds you need to check the index performance and decide to buy or sell just prior to market close. If you are dollar cost averaging and investing for the long term, daily market swings are unlikely to cause a major difference in performance. Slight advantage to ETFs.
• ETF transactions incur a broker commission. Index mutual funds have no transaction costs. Ultra low cost brokers do exist, so this can be somewhat mitigated, but for dollar cost averaging, ETFs will cost a little more. Slight advantage to mutual funds.
• Expense ratios for each are very low. ETFs are typically slightly lower. For example, at the moment VTI (the total stock market ETF) vs. VTSMX (the total stock market mutual fund) is .07% vs .19%. Both are very low compared to actively managed funds that can be 2% or more. To see what this means for performance, I compared the total performance of each over the last 5 years. Currently they are almost identical, VTI is up 69.5%, versus 69.7% for VTSMX. So the mutual fund actually did better. This comparison will vary based on what indexes you are using and which mutual fund product.
• Tax advantage is really none. Both should have minimal distributions, since there is low turnover, and both will generate income from dividends. Capital gains are handled the same.
• Minimum investments for ETFs are one share. Often mutual funds require a few thousand dollars to open the account and then some small amount per transaction ($50 or $100). This is an advantage for ETFs for the very small investor just starting out.
• ETFs can be shorted and Options are available, so calls and puts can be used. Mutual Funds cannot do this. So for the very active trader, ETFs are a much more sophisticated product.

While ETFs and index mutual funds are quite similar, there are some advantages to each. For the long term passive investor, either will serve you well. If you are currently invested in quality index mutual funds, there is no advantage to transferring that to ETFs. If you want ultimate control and have a very low cost broker, ETFs are probably better, but don't be scared away from mutual funds. No matter which you choose, what is ultimately important is your asset allocation, and low expenses. Research has shown those factors to far outweigh market timing techniques over the long term.

Myths about the Government Stimulus Package

I couldn't help but write a quick note to correct misinformation about the Government Stimulus Package. There has been a lot of discussions in both the media and discussion forums.

• This is not merely an advance on your 2008 tax returns. This is an actual rebate of $600 that is in addition to what you would have gotten. Yes you are getting it early, but it is additional money. Which is why it will cost an additional $170 billion to implement.
• The purpose of the stimulus package is to help the economy, not to help the individual. There is a lot of discussion about what is fair, where the cutoff should be, and who is wealthy. This is not meant to help the poor, unemployed, or middle class; it is meant to help the econonmy. Consumer spending drives the US economy, the main purpose is to pump money into retail and raise GDP. Unfortunately the Government can't do that itself, so it needs a proxy to do that, and that proxy is the consumer.
• Opinion: There is no better way to get the money in the hands of consumers than a check. Debit cards, gift cards, etc. cost more, are less secure, less liquid, and provide no real benefits. Changing tax rates such as payroll taxes favor the wealthier and is a logistical nightmare. Plus you need a lump sum amount, not a small amount over many weeks.
• Opinion: This stimulus package is good for votes, but will do little to stimulate the economy. Look for actual spending to increase slightly over the next few months, but it will not be sustained.

Investment Goals

In the spirit of my last post about investing for the short and long term, I decided to keep track of my current goals publicly on my blog. These only include goals outside of retirement. I listed my short and long term goals in the table and show how close I am to achieving them in the bar chart. I'll keep updating them throughout the year. I included the end target date in the name.

• The yearly investment goal includes all investements for the year
• The emergency fund is currently fully funded in a money market
• The new house fund is in a taxable Vanguard account
• The car fund is also being funded in the money market
• The college fund will be in a Vanguard 529 plan
• The new bathroom fund will be in held in a money market

I am currently contributing half of my investment money into a money market, which is building up my car fund, and half into index funds, which is building up my new house fund. My plan is to continue that way until the car fund is done, hopefully in 3 months or less. Then I will start funding the bathroom fund with the money market half. However, in July I will start investing in the College Fund with 100% of my available money, using a 529 Plan, until I reach my goal of $70,000 in 2 years or less. At that point, I will continue with the half long term investing, half short term investing allocation.

Investing for the Short and Long Term

Please be sure to first read my previous post "Are you ready to begin investing?". If you have determined that you are ready to invest, then keep reading. When putting together an investment plan you need to initially consider two things: (1) when do you need to use the money, (2) and how much money will you need. This determines your risk tolerance and volatility tolerance, as well as how much you should be contributing.

If you are planning to have a major purchase soon, using your investment money in the next 1-4 years, then your tolerance for volatility is low. Long term investment goals for 5 years or greater have a higher tolerance for volatility. I recommend splitting your investments between the two different goals.

For short term purchases and emergency funds, establish a high yield money market fund. Using something like ING Direct, Vanguard Prime Money Market Fund, or something similar. "High Yield" for a money market as of February 2008 is considered to be around 4.1%. Look for low expense ratios in the fund, less then 0.5%. I personally use Vanguard's Prime Money Market Fund. This is where you can keep your money liquid and safe, while still earning some return. If you don't need to keep the money liquid you may also consider a CD for a higher yield, however right now CDs are yielding less than money markets as interest rates are expected to continue to fall.

Long term investments for things like retirement and college should be allocated in a diverse portfolio with higher volatility. I do not consider retirement to ever be a short term investment, therefore it should always have a volatile component. Even if you are 64 and plan to retire at age 65, retirement is not a single "purchase" and needs to continue for another 20 or more years. Therefore, it is a long term investment.

Risk vs. Volatility

Often, people are interested in low-risk, high returns, and guarantees. Unfortunately it is impossible to accomplish all simulaneously. I prefer to look at risk and volatility separately. I define here volatility as the change in returns from year to year. While risk is the chance of not meeting your goal. Having low volatility is not necessarily good, as it still may be risky. Most important is the expected return over the long term, as a longer time horizon will smooth out the volatility and lower your risk. Generally, equities are considered to be more volatile, with bonds and CDs much less. However, there may be a greater risk that you cannot meet your goals using bonds and CDs, than with equities.

Determine Your Goal

Whether investing for a car, retiremement, or college, you need to know your end goal for funds. Sometimes, the cost will drive your purchase date, and sometimes the purchase date will drive your monthly contribution. Either way, determine how much you will need and plan how to get there. There are numerous online tools to calculate this such as savingforcollege.com and retirement calculators. They also can help with things such as asset allocation to meet your goals.

For long term investments, a combination of bonds and equities will likely be necessary to meet your target goal, to provide you with adequate return. As equities, have historically provided the greatest return and volatility, these should be used increasingly as your time horizon is long. As you approach your goal amount, shifting your allocation to all bonds or other fixed incomes is advisable.

My Allocation

I have employed for a few years now a simple formula for splitting these investments. First, as mentioned in another posting, I fully fund all retirement accounts. I then take was is left at the end of each pay period and evenly divide it between a money market fund (where I already have a $15k emergency fund) and my equity mutual funds. I use the money market fund for my short term goals, which have included a new kitchen, bathroom, and car. There is always some major purchase I am saving for, but if there wasn't, then I would increase the amount I put in my equity funds. I am currently saving for a new (used) car that I know I will need in the July timeframe. In my retirement account I invest almost 100% in equities, as retirement is at least 32 years away for me. I plan to shift to about 75/25 when 10 years away, 65/35 when 5 years away, and 50/50 when in retirement. The goal is continue to earn an annual income of 6-7% while in retirement to support a 4% distribution and 3% annual inflation. You can see my investment goals here.

My asset allocation in equities is done almost entirely with index funds and I passively manage them, only rebalancing yearly. I'll get into more detail about my asset allocation in another post, but I'll summarize by saying I like a small number of highly diversified funds. We've seen many sectors, such as emerging markets, real estate, large caps, and international funds take turns as the market leaders and I believe in owning them all.

My Super Tuesday Vote

I live in New Jersey and we will be voting February 5 as part of Super Tuesday. I have been waiting to let the dust clear before making a decision, but now that the field has been narrowed, it is time to choose. I will be voting in the Republican Primary, which has become a two horse race. For me, it comes down to a few issues that I base my decision on: taxes, energy, spending, the war, and illegal immigration. On most of these topics, I feel the Republicans pretty much agree, although their implementation may differ somewhat.

I'll give you the bottom line upfront and say that I will be voting for Mitt Romney. Although I may have been voting for Guilliani if he was still running. Now let's look at each of the issues:

• Taxes. They all agree to keep income taxes low, eliminate or fix the AMT, and make the current "Bush" tax cuts pernament. McCain and Romey propose to do this by keeping the current rates. Mike Huckabee and Ron Paul want to do this by completely changing the tax system. Huckabee with the completely unfair FairTax, and Paul by eliminating all taxes. Neither solution would ever be supported by Congress, and thus are not realistic. Romney also would like to reduce corporate taxes. I believe these changes are necessary to keep the American economy strong and make America companies competitive, where we currently have one of the highest corporate tax rates.
• Energy. Everyone agrees we need to lower our dependence on imported oil. The best solution is massively and rapidly increasing our production of nuclear energy for electricity. Aggressively drilling for oil where it currently exists in North America (e.g., ANWR). At the same time, increasing our reasearch and use of alternative energies in our cars. However, this has to be balanced with our food supplies. Tapping into our food supply to be used as fuel causes inflation in all our food prices and may not be the best solution. All the candidates favor a strong, bold energy plan. However, Mitt Romney and Mike Huckabee seem to align best with my views. Ron Paul believes in free market forces to guide energy, but because of the enormous initial expense of building new plants and bringing new solutions from research to the mass market, I believe you need Government incentives. Allowing the best and cheapest solution to merely win out, means the dirtiest coal solutions may be in our future.
• Spending. The theme is low. From the extreme low preached by Ron Paul that is supported by his no income tax plan, to the more moderate levels of the other candidates. John McCain has long been working to end earmarks and proposes the line item veto. However, simply eliminating earmarks will not do it alone. In addition, no new programs should be formed and existing programs need to be scaled back. This is the root cause of where Democrats and Republicans really differ, Democrats want to help America by increasing services and spending, Republicans want to lower costs by minimizing services.
• The War. All candidates except Ron Paul want to finish the fight and come home victorious. Whether you were originally in favor of the war or not, the fact is that we are in it and need to now complete the mission. Paul may like to argue the premise of the war, but we need a President who is going to complete the job decisively and as quickly as possible. This is where John McCain has the advantage in my mind, with his experience and service. The other candidates are talking the right strategy, but are still unproven.
• Illegal Immigration. This is John McCain's weakness, having supported amnesty for illegal immigrants. The other candidates all support strong physical borders, strong screening, and an increase in agents. We need to stop providing support for illegal aliens and instead provide a more controlled immigration process and increasing the speed of the process will encourage immigrants to come in the proper way.

In addition, I like what Mitt Romney accomplished in Massachusetts on health care. To me, the religious views of the candidates are unimportant, unless those views would negatively influence the issues listed above. Remember, there still are the Congress and Courts to keep the President in check. The criticisms of "flip-flopping" have been used on both Romney and McCain so I look at that as a wash. McCain will probably win the majority of votes on Super Tuesday, however it will be interesting to see if Romney can keep it close.