Today we’ll reveal the single most important success factor for peer to peer lending investors.

As Matt has discussed before he used to be a borrower on Lending Club but is now an investor with a growing portfolio. Peer to peer lending provides an excellent opportunity for investors to start out small (the minimum investment is just $25) and slowly grow their investment. There are two main players in peer to peer lending: the aforementioned Lending Club as well as Prosper. The principles discussed in this article will apply to both companies.

An Average Return of 10%

The average return for investors in Lending Club and Prosper is around 10%. So even if you earn the average return you are doing better than almost any other fixed income investment. The big question is, as an investor how do you ensure that you earn at least the average return? The key is diversification. You need to spread your risk among many loans.

Here is an example to illustrate how important diversification is for your return. Let’s assume that you have $1,000 to invest and you spread your risk over four loans at $250 each. If one of those loans defaults immediately then you have made a big mistake and thus are down 25%. Now, if your $1,000 is diversified among 40 loans of $25 each and that same loan defaults, you are down only 2.5% of your total. A 2.5% loss is much easier to recover from than a 25% loss.

Unless you are investing a large amount of money (say more than $5,000) I think it is really important to keep all your investments to the $25 minimum per loan. Unless you are very lucky you will likely have some defaults over the life of each loan, even in the lower risk loans, so it is best to minimize the financial impact of any such losses.

How to Diversify

Now you have seen the importance of diversification it is important to put this into practice. There are two main ways to ensure you create a diversified portfolio of loans.

1. Automated Plans

Both Lending Club and Prosper offer some kind of automated plans. This is where you just choose your amount to invest and your investment criteria (such as risk level) then they will invest in the largest number of different loans that meet your criteria. Now, once your account has been open for a while you will start to get cash building up in it from the interest and principal repayments. Depending how much money you have invested this can build up pretty quickly. So every week or two you should login and put your cash back to work, where you can choose the automated plans again to diversify your new investment.

2. Choosing Loans Individually

If you have the time and the inclination then you can choose which loans to invest in manually. When confronted with typically 500 or more loans on the Lending Club or Prosper platforms it can be a little bit overwhelming trying to choose loans. This is why both companies provide filters so you can select some criteria so you can include only the loans you want. For example, you can choose to only include loan grades B, C and D. You could exclude loans where the borrower has had a delinquency in the past two years or if they have been employed in their current job less than a year. There are dozens of filters to choose from and by selecting some you can whittle down the large number of available loans to something much more manageable. Then you can view each loan and make a decision whether to invest or not. Of course, as I said above, I urge you to stick to the $25 per loan investment if at all possible.

The Final Word

Nothing will potentially lower your returns more than an undiversified loan portfolio. You will always run the risk of one default negatively impacting your returns in a big way. A broad diversification of loans will spread your risk and give you the best chance of receiving at least the average return. And at around 10%, the average return is pretty darn good.

About the author:  Peter Renton is the publisher of the Social Lending Network, a blog dedicated to peer to peer lending. He is also on Twitter @SocialLoans.