I thought I would repost this on my blog because it is very good information how to build a profitable Prosper portfolio.

Diversification and Setting Limits

01/8/08 posted by WealthBoy

I would like to provide the Prosper community with some of my thoughts on building a profitable lending portfolio. Of course, what such article is complete without mention of diversification? Certainly anyone could tell you that diversifying your portfolio by spreading the risk over multiple investments is a good idea. But how many different loans should you invest in? At least 30!

Diversification

Why 30? A well-known statistical rule of thumb states that you should try to use a sample size of at least 30 in order to improve the accuracy of any analysis performed on normally distributed data. According to the central limit theorem, “as the sample size n increases, the distribution of the sample average approaches the normal distribution with a mean µ and variance σ²/n irrespective of the shape of the original distribution.” That means that even if data is not normally distributed, as the sample size increases the distribution will approximate that of the normal distribution.

It is very likely that the average return for unsecured loans is normally distributed, so the rule of 30 should apply well to peer-to-peer lending. Even if the average return isn’t normally distributed, the central limit theorem states, that the larger the sample size is the better it will approximate the normal distribution anyway. This means that the more loans in which you invest (with equal amounts per investment), the better your chances are in achieving the average expected return. Please note that I stated “average expected return” and not average interest rate. When I say average expected return, it means average interest rate - average net defaults - average fees.

Setting Limits

That brings me to the next topic of setting limits. It is very important to consider potential costs associated with your portfolio when placing bids. You should consider the probability of defaults and fees, as costs of maintaining the portfolio. When bidding on loans with lower debt grades (i.e. higher risk loans), you will need to set higher minimum rates in order to compensate for defaults and fees. Each bid placed should take these costs into consideration, as well as the desired total return on the portfolio. The “Expected Return” calculation on the Prosper bid page is an excellent tool in helping to decide at what interest rate to place your bids. (Editor’s Note: Another great tool is the Marketplace Performance Tool.)

Of course, each individual loan will ultimately either default or be fully repaid. Therefore, on an individual basis the actual cost of a loan default is much higher than the estimated cost. If a loan defaults, the cost will essentially be the original amount lent minus any principal and interest paid up until the time of default. However, if enough individual loans are made with similar estimated costs, the figures on the bidding page should provide a good estimate of the costs on the total portfolio.

Once you have placed your bids in accordance with your desired overall portfolio performance, you need to be patient and wait for the listings to close. If you’ve bid on a good listing, there should be plenty of other bidders on the loan and it should reach 100% funding. Often after a bid has reached 100% funding and it approaches the expiration, a bidding war takes place. I believe that the activity taking place is a result of the actions of two types of bidders:

Those looking for a good deal (that matches their risk profile) that will close quickly.
Those that were outbid and rebid to ensure that they win.

Do not become the latter! If you are outbid on a listing, do not be compelled to rebid. It is not a competition where you win a prize if you win the bid. If you were outbid, it was because the marketplace was willing to take on more risk than you. Besides, at the rapid pace that Prosper is growing, there will always be plenty of new listings to bid on.

It is of the utmost importance to be very patient when investing funds. You should draw the line and never cross it. You should expect to lose a lot of bids. You should also expect to do a lot of bidding before having a winning bid on a funded loan. I’ve found that only about 10% of my bids are being funded, which is just fine with me. As soon as I lose a bid, I look for another loan to bid on with the money returned to me. I think that all too often, lenders cross the line or even worse they never drew a line to begin with.

Prosper

If you properly diversify your portfolio and properly set your limits, you should be well on your way to building a profitable lending portfolio. I would recommend that you invest at least $1,500 and spreading it over 30 $50 loans. If you invest more than $1,500, investing in more than 30 $50 loans will make your results all the more predictable. If you invest considerably more (on the order of tens of thousands or more) it may not be as easy to keep your bids as low as $50. However, if you do keep your bids down to just $50, your results will be much more predictable. It will just take much longer for the large investment to eventually reach funded loans. All it takes is a little discipline and a lot of patience.

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WealthBoy is a new Prosper lender (BankOfY) and writes the personal finance blog WealthBoy. He performs financial and statistical analysis in his day-to-day job. He enjoys following the financial markets and seeking out new ways to invest. He is well versed in investing in mutual funds, stocks, and options and has found peer-to-peer lending to be another good method for investing. He also loves to watch Florida Football and Florida Men’s Basketball.