Before attempting to develop a strategy for picking loans, I thought it would be worthwhile to see how an uninformed investor would do if they stumbled into Lending Club and invested at random.
To see what the return would be, I wrote a simulation that randomly picks 100 loans out of the pool of full term loans described in my post on Lending Club Defaults rate here. Hypothetically investing $100 in each loan resulting in a total 10K investment. To make things simple only 36 month loans were used and they were all assumed to be issued on the same date. The return from this investment was calculated at the 36 month point using the Internal Rate of Return calculation described in a previous post.
Doing these steps once doesn't really tell us much about the overall distribution of returns. So this process was repeated 10,000 times. A sample of the simulation output is shown below.
Statistics on the 10000 trials are:
- Minimum Return = -1.7 %
- Maximum Return = 7.9 %
- Mean Return = 3.74 %
- Standard Deviation = 1.518
Returns are evenly distributed around the mean with a slightly extended left tail into negative territory. An uninformed investor randomly picking 100 loans could do very well and see a 7.2 % return or just as likely see a negative return. But on average they will be 3-4%.
This graph highlights a very important point about any claims of performance in investing. With a little bit of luck even the worst of investors can see a much higher than average return. The key to evaluating investment strategies is seeing how it holds up against a large number of unforseen examples.