Strategy for Investing in Micro-Loans

Eggs. Baskets. You get it.

Many bold, value-oriented money managers prescribe to a theory of focused investing. Focused investing involves investing your money in just a few baskets, instead of over-diversifying. Joel Greenblatt, manager of Gotham Capital, tells us in his excellent book, You Can Be a Stock Market Genius, “After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small, and overall market risk will not be eliminated simply by adding more stocks to your portfolio.”

This is an approach used by some of the best investment managers. The theory is simple, why put 1% of your money into your 100th best invest idea, when you could put 10% of your money into one of your best ideas?

With stocks, I think this is a great theory, idea. If you’re truly convinced, after doing the research, that a particular idea is one that will make you money, and you believe that you’re a person who has the knowledge to make that sort of call…then I think you’re fully justified in investing this way.

When it comes to micro-consumer loans, though, focused investing really doesn’t have a place. This approach works with stocks because they have almost unlimited upside. You can focus your ideas, and one great idea can dwarf your mistakes. The value of the stock can’t go below zero, so the downside is limited to whatever you pay for it – and the upside could be 1000%. When investing with the micro-loan companies, like Lending Club or Prosper (or whatever – those are the two I’m familiar with), it’s important to stay diversified as possible. If you have $1000 to invest, for instance, the maximum diversity you can have at $25 per loan is 40 loans. That’s really not very many. In fact, only being able to diversify into 40 loans is actually extremely risky. Banks make money by being able to spread their risk amongst thousands of loans. They try to make every decision as accurately as possible – they wouldn’t lend to anyone that they thought would default. You won’t either – but I suggest, if possible, that you spread your money out over two or three hundred loans. Good luck and thanks for reading.