WealthBoy is new on the scene and assuming he keeps posting I think he will make a welcome addition to the Prosper community.

A couple of days ago, he wrote a guest post for the Prosper Blog: Diversification and Setting Limits.

In it, he talks about diversification and the MINIMUM number of loans required to be adequately diversified — 30!

Why 30? A well-known statistical rule of thumb states that you should try to use a sample size of at least 30 in order to improve the accuracy of any analysis performed on normally distributed data. According to the central limit theorem, “as the sample size n increases, the distribution of the sample average approaches the normal distribution with a mean µ and variance σ²/n irrespective of the shape of the original distribution.” That means that even if data is not normally distributed, as the sample size increases the distribution will approximate that of the normal distribution.

It is very likely that the average return for unsecured loans is normally distributed, so the rule of 30 should apply well to peer-to-peer lending. Even if the average return isn’t normally distributed, the central limit theorem states, that the larger the sample size is the better it will approximate the normal distribution anyway. This means that the more loans in which you invest (with equal amounts per investment), the better your chances are in achieving the average expected return.

30 * $50 = $1,500 (not an insignificant sum).  Personally, I think right number is no more than 2% of your portfolio in any one loan. $50 / 2% = $2,500 or 50 $50 loans.

None of this is to say, “You have to put in this much money,” you could put in less.  The fewer loans that you make the more random chance will come into play.  If you make 1 $50 your loan will either pay to completion or default and you are betting your Prosper experience on the outcome.  If you make 30 or more loans you are a statistical lock (2 standard deviations) to have your expected return match the marketplace for similar loans.

The out clause — similar loans.  Don’t invest in HR, E, or even D without doing your homework.  In fact, don’t invest in any loans without doing your homework.  (Homework is to use and understand this tool: Marketplace Performance Tool) Extended credit comes into play and you should have a firm grasp of the marketplace before manually bidding.  Not interested in understanding the marketplace? Luckily, Prosper has made it easy to invest and proper diversify with Portfolio plans. 

Regardless of your choice of bidding methods (manual, standing orders, or portfolio plans) I encourage you to properly diversify.  Listen to WealthBoy and invest in at least 30 loans or better yet listen to RateLadder and invest in at least 50 loans. 

If you are interested in trying Prosper I encourage you sign up via this link: New Lenders Receive $25 Activation Bonus.

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