RGF in the Prosper forums just made the best post I have seen as an introduction to risk on Prosper.  I am reprinting the entire post.  Here is a link.

I’ve seen a lot of comments about the high risk associated with lending on prosper and “only lend what you can afford to lose”, comments like that. I don’t think people that state these things are really considering what “risk” means, especially in an investing context.

Risk is generally considered the standard deviation of returns. Without getting into boring statistical analysis, “risk”, properly defined, is a measure of the volatility of possible returns. Short term treasury bills are generally considered the closest thing out there to risk free (you could also consider bank CD’s as risk free). Your return is known and will not vary at all. Among the riskiest are emerging market stocks or foreign small stocks (or the craps table).

So, the question to me, is, for a well diversified prosper loan portfolio of investment grade loans (AA, A, B, C) how risky is it? Is it as risky, say, as the US stock market? The problem for most investors is they’re biased from a “recency” perspective. In other words, the risk they associate with the stock market is based on what has happened in the last 3-5 years, that’s why you see people write things like “I can get 14% in the stock market”, nope, you can’t. This is not an appropriate way to assess risk. The long term inflation adjusted return of the US large cap stock market is a little over 8% (you’ll often read 10-11%, this does not subtract out inflation). To earn this 8%, the returns are dramatically volatile. There are historical years where you’ve lost 30% and others where you’ve gained 40%. There are single days where you’ve lost 20%.

So, is lending to investment grade prosper loans going to be this volatile? Well, it’s definitely not going to be this volatile on the high side, you are not going to gain 40% in a year, it’s just not mathematically possible. Your best year is your average interest rate minus prosper’s .5% fee (if you have no defaults). Is it this volatile on the low side? Is it possible, if you’re lending to people who could get a loan at a bank, is it possible to have a 30% default rate? If you’re well diversified, your loans should be similar to the industry in general, so is it possible to have a year where 30% of consumers with good credit default on their unsecured loans? Note that even if 30% did default, you’d still earn 12% or whatever on the remaining 70%, so your loss would be around 21.6%. You’d need have more like a 40% default rate to lose in a year what we’ve seen several times in the US stock market.

Prosper stats are short, and it’s very easy to draw very poor long term conclusions by looking at short term results, but, intuitively, to me, I think it’s virtually inconceivable you could have a 40% default rate lending to people with good credit, barring some huge national travesty (successfully invaded by a foreign power, the supervolcano under Yellowstone erupting, asteroid). Default rates this high would put banks at risk of going bankrupt. There is nothing historically even remotely close to this (the S&L disaster was not necessarily caused by defaults, but more by leverage, basically having their cost of funds variable and their loans in long term fixed loans in an inflationary environment, which resulted in an upside down spread where their cost of funds exceeded their returns). I’ve been in lending and collections for most of my adult life (20+ years) and it’s hard for me to conceive a year where lending to strong applicants would result in more than a minimal loss. I’ve just never seen it happen.

I think it’s inescapably clear that intelligent lending on prosper is probably going to be considerably less risky (properly defined) than investing (even diversified) in the stock market.

In investing, risk and reward are always intertwined. To get more return, you must take on more risk. This is so clear that anyone selling high reward low risk investments is clearly either 1) horribly misinformed and doesn’t understand what they’re selling, or 2) a con artist. Either way, if you see this, you should A) make sure your wallet is still in your pocket, and run.

The question, and it’s a question that I believe will determine whether or not Prosper survives, is whether the long term risk/reward relationship associated with prosper lending is one that will find a niche in the investing world. For example, if it’s ultimately determined that the long term results (average return) of lending on Prosper shows that the return is inferior to bonds, and the risk is greater than bonds, i.e. it is in both ways an inferior investment, Prosper is probably doomed.

So what does the early evidence show? From what I’ve seen, A-C lending is resulting in an average return of around 9%. This is superior to bonds and inferior to stocks (when you add inflation back in). The risk is less than stocks (so you’d expect the return to be smaller). I think it’s too early to determine if the if the risk is more or less than investment grade bonds.

I think the early evidence indicates there is a niche here. Add in there the possibility of earning above average returns (by doing more due diligence and analysis than the average lender) and I think it’s conceivable that this investment could dominate the stock market, i.e. higher returns at lower risk. Of course, this would be partially mitigated by Prosper’s three main deficiencies as an investment, 1) your investment is not liquid (though I think prosper is trying to create a secondary market to allow people to sell a portfolio), 2) the tax treatment is horrific, in that interest income is taxed as regular income the year earned, and not like capital gain which can be deferred for decades and then paid at the lower capital gain rate, and 3) the time required to maintain a portfolio (buying and holding an index fund or a targeted retirement fund is roughly a million times easier).

However, even if it does show itself to be either totally inferior to another investment class or totally superior, in terms of risk and reward, I would think market forces will either force up returns (by a lack of bidding) or force them down (by aggressive bidding) until it is neither superior or inferior to another asset class.

I think it will survive. It’s greatest strength will be very low correlation to other asset classes.

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