Friday, February 24, 2012

Does Lending Club Advocate the Martingale System?

Gambling's not all neon and brick walls, you know.
There was a time in my life when I was spent a lot of time reading about gambling strategies (and I'm not talking about penny stock tips).  As you might have suspected, that time in my life ended pretty poorly (no pun intended).

However, as I was looking at my account with Lending Club, I realized that they appear to be advocating a similar strategy that some gamblers do.

This strategy is known as the Martingale System, and here's how it works.

The Martingale 

Let's say you're playing blackjack.  You wager $5, and the dealer has 19 to your 18, so you lose the hand.  Now, you double your bet to $10.  Sadly, the dealer hits a blackjack, and you lose again.  The Martingale System says that since it is improbable that the dealer will win infinite hands, every time you lose, you should continue doubling your last bet until you eventually win a hand.  When you do win, you will win back both your original bet as well as a small profit equal to your original bet.

It's a slam dunk, right?  There's no way to lose!  Let's all go to Vegas and get rich!

Unfortunately, for the Martingale to work, you need both a ridiculously high risk tolerance and an infinite amount of money (though, if you had infinite money, why are you gambling in the first place?).  Let's look at why.

The Martingale is very palatable in small doses.  For example, let's say that instead of losing your second bet above, you won it.  You wagered $10 to receive $10 (which covers your original $5 bet and gives you $5 in profit).  That's easy money, right?  But take a second to think how quickly your wager will double if you continue to lose.

Hand 1: $5
Hand 2: $10
Hand 3: $20
Hand 4: $40
Hand 5: $80
Hand 6: $160
Hand 7: $320
Hand 8: $640
Hand 9: $1280

By the sixth round of betting, you'll need to put out $160.  By the ninth round of betting, you'll be into four figures.  I don't know about you, but my will isn't nearly steely enough to bet $1280 so that I can regain all my losses and come out $5 ahead.

This is the basic problem with the Martingale: while it may be hugely unlikely that you'll go on a huge losing streak, it is far from impossible, and your risk tolerance (and the depth of your pockets) probably won't allow you to continue doubling your bet forever.

What Does This Have to Do with Lending Club?

In order to promote its legitimacy as an investment option, Lending Club has started broadcasting the idea that no one in the history of the site who has ever invested in 800 notes (at $25/note, that's a $20,000 investment) has ever experienced a negative return (e.g., had so many defaults that the investor lost money).

Frankly, I think it's a smart idea for Lending Club to promote this since P2P investing is still off-putting to a lot of people.  However, I think their logic is a little bit fuzzy.

On the site, you can also check to see what percentage of investors lost money at both the 100 note and 400 note level.  For those with 100 notes, 1.03% have lost money, while only 0.16% of those with 400 notes have lost money.

Why would Lending Club include these levels?  It's hard to know for sure, but I suspect that it is to encourage people who, like me, have only purchased a handful of notes and have already had a negative experience.  If you only have 10 or 15 notes, and one person defaults on a loan you've bought into, that will almost certainly give you a negative return for (at least) the year.  This can sour the P2P Kool-Aid pretty quickly.

So, Lending Club is basically saying, "Come on!  Double-Down!  If you invest $2,500 (to get to 100 notes), you'll only have a 1.03% chance of losing money."  As our wary investor continues to buy and eventually gets to 100 notes, he still finds that he's losing money due to deadbeats.  Lending Club says, "Tell you what, if you get to 400 notes ($10,000), you'll only have a 0.16% of losing money."  Our investor steadfastly continues to invest, only to find out that he is part of the unfortunate 0.16%.

Let me ask you this: if you've already sunk ten grand into something, and you've had the bad luck to lose money on it, are you really going to want to stick another ten grand in?  Even if nobody else (so far) has lost money if they've invested in 800 notes?

Just because something hasn't happened thus far does not mean that it will not happen to somebody in the future.


So what am I saying?  Am I suggesting that people shouldn't invest in P2P sites like Prosper and Lending Club? Far from it.  I've written before that I invest with Lending Club because I believe there's a very good possibility of good to great returns, and I will continue to do so until my opinion changes.

All I am saying is that we should all be wary of investments that promise assured positive returns if we'll just invest a little more than we have already.  The only way to get assured returns is to invest in an FDIC insured investment like a CD or savings account.  Your returns in doing so will be much less than you might receive from the stock market or P2P sites, but at least you can't lose money (unless the U.S. government falls, in which case you'll probably have bigger concerns than your rainy day fund).

What do you think?  Is Lending Club being cheeky by pushing folks to get to 800 notes?  Let me know in the comments.

Photo by fPat.


Daisy said...

Interesting! I've never even heard of the lending club.

Bryan said...

Yeah, Lending Club is an interesting idea. I've been spending a good amount of time looking into it to see if I can make money with it, and I've been tentatively investing small amounts. Others have had success with it though, so I'm hoping I can too.

Peter Renton said...

If you equate Lending Club to gambling then I can certainly see the parallel. But let's be clear here - Lending Club are making no promise of assured positive returns - they are merely pointing to historical returns something that most asset classes do.

I have never seen the argument that people should double down if they are losing money. But if you are investing in 10 notes and have had two defaults that is hardly indicative of the success of p2p lending. You really are gambling if you invest in so few notes.

I always tell people if you really want to give p2p lending a serious try you need $5,000 - this will give you 200 notes and with a common sense investment strategy you should generate positive returns. But of course, there is no guarantee with that and people who are concerned they may lose principal should stick with FDIC insured investments.

Captain Credit Crunch said...

The parallel is just superficial but not mathematically equivalent. In the Martingale example, you have an equally likely chance of winning with each hand you play, but the stakes continue to increase. When building a portfolio, adding another loan makes the entire portfolio MORE likely to achieve the average charge off rate (i.e. profitable) because the variance of the portfolio is reduced as its size increases. Plus, your additional capital is the same as it ever was, $25. I made a nice post on that outlined the math behind the 100, 200, 400 thing.

Captain Credit Crunch said...

Here is the link to that post. It's a ways down by me "credit crunch."

Tim said...

Also, Lending Club is for patient, careful people who will spend the time to consider even a $25 investment a 'big deal'.

You need to have a set of criteria that means something to you, identify loans which mean that criteria, and only invest at $25 or $50 at a time, to limit your exposure. [at least, limit it to small investments like that while you are building up a portfolio].

$5k invested with $25 individual notes is pretty diversified. I think if you do your homework, and come up with reasonable strategies for investing, you can expect to not lose money. 200 different individuals to invest in spreads out the risk among many people.

If you are going to get frustrated and just invest all your money in one person because you have a good feeling about them, I would say that lending club is not for you then. :)

Michael said...

Martingale system involves doubling your bets to break even. Not making more bets to reduce variance. The proof that Lending Club has a positive return is that the more notes invested insures positive return. You can not find a single game like this in a casino with standard house advantage over 800+ bets and ensure 0% loss rate.

If you understand gambling then you will understand the concept "risk of ruin" which is the odds you lose all your money. By investing in $25 notes over 5,000 the risk of ruin is 0.0000090%. What Lending Club did was extend this out to risk of making no return. The point that happens is approximately 800 notes or 20k of $25 notes. The approach of having hundreds of notes to reduce risk yet have a constant high is a strategy used with junk bond investing as well as index funds like the S&P500.

Anonymous said...

Lending Club should be a long term investment in my opinion. Put $20k in to start. If you don't have that much, forget about it. Then, as monthly payments are paid, take the payments and reinvest... over and over and over again. Go way beyond the 800 notes that $20k provides and TRUELY diversify. Do this year after year after year.

If you look at it from that perspective then you will most likely see amazing returns. But if you have little money, find a more stable investment. Like you said, just one default can screw over a $500 investment... it's just too risky if that's all the money you have to invest.

In my opinion, Lending Club investments benefits the rich the most because it allows for vast diversification that counters the defaults. Like a bank.