With the economy a bit unsteady, the importance of diversification cannot be ignored. WealthBoy wrote a great post to introduce diversification on Prosper where he observed that a lender should pick up at least 30 different loans to help spread out the risk. Whether you’re diversifying by picking up 30 or 130 loans, it’s important to not just talk the talk, but to walk the walk. If you’re going to diversify, truly diversify.

The power in diversification comes from picking up loans that succeed or fail more or less independently. This independent behavior is characterized statistically by looking at the correlation between two investments. To explore this, travel with me to Sandusky, Ohio for a minute to think through this. Tommy Boy Callahan is about to go on a sales trip to save his family’s auto parts business. If I’m a lender with 30 loans out to all the various employees of Callahan Auto, I’m taking a large risk. If Tommy fails on his trip, all the plant employees will be out of a job, and a very high percentage of my loans will go belly up. In this scenario, there’s a high correlation between one of my loans failing, and one of the other loans failing as well. A lender could have a huge number of loans to the workers, but it wouldn’t do me any good because they’re all likely to fail together. In other words, my 30 loans have only created the appearance of diversification.

To truly diversify, it’s important to distribute those eggs across multiple baskets. Spread loans across multiple states to help avoid local downturns and across different credit grades, incomes, and jobs to target different steps on the socio-economic ladder. By spreading out your lending, you can reduce correlation between loans and reap the benefits of true diversification.

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Mike is a Prosper Lender and blogs about Prosper for Prosperous Land.

When Prosper created their portfolio plans, they added a tool to help new lenders enter the marketplace. It assembles a portfolio of loans whose only objective is to track the average loan return in the specific market slices, much like index funds have done with the stock market. Want to play it conservative, you buy a S&P 500 Index. Feeling aggressive? Try the EAEF Foreign Stock Index. If a lender is interested in tracking the loan market, new lenders can establish portfolios without the learning curve of manual bidding.

Those of us who take a managed fund approach to our lending by using manual bids will have to be careful because the portfolio plans will change the bidding environment. If the portfolios are widely adopted, we should expect loans within the portfolio’s umbrella to be in higher demand. Higher demand for certain loans will result in lower interest rates for those loans, lowering the possible return on investment. A similar effect has been found when the S&P 500 adds a new stock to the portfolio.

At the same time, it creates opportunities to find nuggets that are outside of Prosper’s four portfolio plans. This is risky territory (otherwise it would be inside the portfolios), but risk is a problem for lenders when they’re not paid appropriately to take on the risk. Careful efforts to mitigate risk can drive down the net defaults and appropriate bidding can compensate for the remaining risk. For example, non-autofunded C grade loans with 0 delinquencies and 2 to 3 inquiries are more dangerous than those with the balanced portfolio preferred 0 or 1 inquiries (-9.05% vs. -5.02% net defaults respectively). If you take those 2 to 3 inquiry loans and further constrain bidding based on other risk factors like DTI and loan amount ( DTI less than 20%, amount less than $10k), it’s possible to find listings that have better net defaults (-3.97%) than those found in the portfolio criteria.

This was just one of many opportunities. Prosper doesn’t add these more finely tailored criteria to the portfolios because there aren’t enough listings to support the volume of loans portfolios demand. For individuals willing to dig deep around the periphery however, it’s a veritable gold mine.

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Mike writes for Prosperous Land.