Why Loans should constitute 20% of your Portfolio


Traditional Portfolio Allocation {100 — Age = Equity Allocation}

For decades a rule of thumb for asset allocation has used fixed income component to be equal to your age. For example, if you are 20 years old the fixed income component should be 20%, rest 80% (100 — your age) should be equities. As you age you increase this fixed income component proportionately and so on.

The idea was when you are young you have more time to recover if there is a downfall in stock market and as you age that time reduces and hence your risk taking capacity also goes down. Recently this idea has been challenged by a lot of new rules especially “110 — Age” & “120 — Age” proposals.

The prime reason for the new models is the falling US treasury yields. The Graph below truly demonstrates why an investment in US treasury is no longer a great investment strategy

10 year US Treasury Yield


Investing in Alternate Assets


Alpha Rock an alternate asset fund manager has produced the returns chart above where they have been able to show that inclusion of alternate assets can not only improve returns but can also reduce volatility over traditional allocation.

If you look at Yale endowment the allocation alternate assets has consistently grown over the years


These alternate assets not only give great returns but are also exhibit much lower correlation to the traditional assets. In their paper “Modern Approach to Asset Allocation & Portfolio Construction” , Charles Schwab also contends for using the alternate assets as part of the modern portfolios and their diversification benefits.


Issues with Traditional Alternate Assets for Individual Investors

As an individual investor we would love to invest like a Yale endowment fund and get superior returns, but the choices that exist when you are investing hundreds of millions of dollars are very different compared to a normal investor who normally invests between US$5K — US $ 250K.

Also a lot of these alternate investments are highly illiquid and can have holding periods of more than a decade. This kind of long holding periods usually do not work for most of the individual investors that are looking for opportunistic investments and have liquidity needs.

Loans a Perfect Alternate Asset for Individual Investors

Loans as an alternate asset class provide a perfect investment vehicle for individual investors that are looking to diversify their portfolios.

Superior Returns

Current 10 Year US treasury yield is stuck around 3% which is the highest yield in last decade. If you are using a Robo Advisor to manage your portfolios their fixed income returns are nearly 0 or negative as per Barrons


On the other hand if you take a simple approach on Lending Club and just invest all your money in A ratings loans (table below, 36 month term loans for A4, A4 & A5) your average return is more than 5% for matured loans (loans that have 24 months of maturity).

Returns of Lending Club Loan Vintages (36 month)

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Shorter Term

For 10 year US treasury you are required to invest your money for 10 years, while there is a secondary market for the treasuries the pricing can be volatile and suffers from a lot of interest rate risk. The Robo Advisors are looking for an investment of 20–30 years. On the other hand average repayment age for 36 month (3 years) Lending Club loan is less than 2 years (24 months).

Greater Diversification (Lower Correlation)

Loans unlike corporate bonds have much lower correlation to the equities and thus provide a much better diversification for same amount of investment compared to bonds. Due to short life span of the product it is a hard metric to produce a data result for that but a heuristic analysis proves this right.


Portfolio for all ages with 20% allocation for loans

As we talked in the beginning the rule of thumb for portfolio allocation is : % of fixed income = your age. With superior return of loans this rule of thump will hold great for any ages.

Age 20–30

  • Allocation: 80% Equity , 20% Loans
  • Benefits:
  • Good returns that are required for growth
  • More diversification in the portfolio

Age 30–40

  • Allocation: 70% Equity , 20% Loans, 10% Treasuries + Bonds
  • Benefits:
  • Some risk aversion with addition of treasuries
  • Add a small income component with the bonds
  • Maintained good returns that are required for growth
  • More diversification in the portfolio

Age 40–50

  • Allocation: 60% Equity , 20% Loans, 20% Treasuries + Bonds
  • Benefits:
  • Mode risk aversion with addition of treasuries
  • Increase the income component with the bonds
  • Maintained good returns that are required for growth
  • More diversification in the portfolio

Age 50–65

  • Allocation: 40% Equity , 20% Loans, 40% Treasuries + Bonds
  • Benefits:
  • Having loans giving us good returns allows us to reduce our dependence on equity
  • 60% of our portfolio is in fixed income component that is uncorrelated to each other
  • Maintained good returns that are required for growth
  • Security for retirement income

Age > 65

  • Allocation: 25% Equity , 20% Loans, 55% Treasuries + Bonds
  • Benefits:
  • The Loan portfolio at this age can be converted to an income producing component
  • In addition to the loans the Bonds can provide another income stream
  • 75% portfolio in fixed income is extremely safe
  • Maintained good returns that are required to ensure that you do not run out of money in retirement (4% returns)
  • More diversification in the portfolio

Conclusion

World of investing is evolving fast with new assets like Bitcoin coming to investment horizon it is always hard to create a portfolio that serves your needs and can ensure a safe and secure retirement. Loans as a portfolio component in retirement portfolios can provide a critical balance that is needed between need for growth and fixed income diversification. Any portfolio built with Loans as a component can expect to get good returns and provide sufficient diversification.

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Disclaimer: LendingClub Notes are offered by prospectus filed with the SEC and you should review the risks and uncertainties described in the prospectus prior to investing in the Notes. Croudify is not a registered investment adviser, and the information provided is not intended as investment, legal, or tax advice. LendingClub Notes are not insured or guaranteed and investors may have negative returns. Historical Returns are not a promise of future results. Consult with your investment or financial advisor prior to investing.


Originally published at Croudify.