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How to Beat the 10% Compounding Myth

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I had mentioned previously that for a number of reasons, it's very difficult to earn 10% interest on your money. However, I think I found a way to do it. Of course there's some risk involved. For those who get squeamish about the possibility of losing money, you might want to look away - this could get ugly.

If you are a regular reader of Lazy Man and Money, you'll know that I'm a bit of a proponent of Prosper.com. I think it cuts out the middle man in the banking business. Borrowers get better rates by getting a large mass of people bidding for their loan. Lenders make out by making more than they could in some other investments. I've chosen to be a lender in an attempt to get a return on my money.

Looking at my account, I have nearly 70 loans, mostly consisting of $50 loans to different borrowers at a rate approximately at 24%. At first glance it feels like I'm a loan shark or credit card company with that rate. It's true that I typically loan to those who are greater risk of default, but I'm at least diversified amongst them. I also have nearly 50% of my money in lower risk credit grades of C and higher. Eric's Credit Community is a site that analyzes the Prosper community. One of it's more useful stats is an estimated risk adjusted return on investment (ERAROI). According to the site, my ERAROI is over 17.5% when taking in account for risk, amazingly (at least to me) in the top 50 of all lenders with at least 25 loans.
So how does this look from the top to the bottom:

  • 24% - Start
  • 23.5% - After Prosper's cut for doing business (.5%)
  • 17.25% - After adjusting for risk
  • 13.5% - After adjusting for Inflation of 3.75% (just a rough average)
  • 10.125% - After a 25% tax

This is far from a guaranteed gain, but I think it has a place as part of a well-balanced portfolio.

Last updated on March 25, 2007.

This post deals with: ... and focuses on:

Investing, Prosper

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8 Responses to “How to Beat the 10% Compounding Myth”

  1. Digerati says:

    You also need to factor in the time it takes prosper to get your money working for you. You may make 24% but if the money is only invested (it takes them a couple weeks to complete the loan process) half the time, you make only 12%. Unfortunetly, you have to give Prosper your money, then wait for the rest of the pool to complete the loan. That process takes time, and so even if you earn good returns on your individual investments, your money is tied up way too much to get a good returen. Stay with prosper for a while and see what the real returns end up being.

  2. Lazy Man says:

    It’s true that money does sit on the sidelines not making interest. I tend to move $100 in a couple times a week and get that in loans as soon as possible. I put that money into two as quick as possible. True it’s taken me nearly a month in EXTREME cases, but most of the time it’s about two weeks. However, the money is invested for 3 years. This means that even in the worst case, the money is working for me 36/37th of the time. In the better cases it’s earning me interest about 71/72nds of the time. The exception is when a loan gets paid back early. That’s happened to me once (in 70 loans) and to be honest, I was happy to pocket the interest and move the money into the next loan.

    So while it may feel frustrating and seem like an eternity to get your money in a loan, I’m not sure it’s mathematically a problem. Let me know if my math or reasoning is off.

  3. Wow, this is very interesting indeed. I don’t think I can take the risk of lending to others though. I’m way too risk averse when it comes to scaled down transactions. We’ve previously lost money on endeavors such as this in the past so I’ve balked from them…. Good luck with your loans!

  4. Prosper is a very interesting investment opportunity. New lenders should spend some time in the forums ad gather information, hints and strategy advice of experienced lenders to avoid costly mistakes.

  5. […] I’d like to thank Prosper for recognizing my post How to Beat the 10% Compounding Myth in their Prosper in the Blogs […]

  6. nicebank says:

    Great stuff. I’ve been digesting a lot of your posts and wish I’d read them before I starting bidding!

    2 questions –

    With half of your portfolio in the lower risk loans, what is your ERAROI for your entire portfolio? Also at 24% average for the riskier loans, what is the average credit rating – E, HR?

    Also, Digerati raised a great point –you need to factor in the time your money isn’t earning interest. Anybody know a formula to factor that in assuming a average lag time?

  7. Yosef Katz says:

    Hi,

    Another question to Lazy Man. I have been investing in social lending for 8+ months and seeing good progress (compared to other things out there). My question has to do with overall investing and how to look your earnings.

    One of my thoughts is if I want to have some item I pay for regularly covered so that my direct work effort is not expended to cover its cost then I must be making x to cover that item. So if I pay $86/month on my gas bill and I have an investment that gives me a consistent after tax/after inflation yield of, say, $100/month then my gas bill is paid for as long as things don’t change…

    But if I am withdrawing my profit and only retaining $14/month then that is my compounding picture.

    What my rambling is trying to get at is how do you view your cash flow and profit from your account in a social lending program like Prosper (or LendingClub)? I have seen that there is x amount of cash flow and if I reinvest all of it then that grows at a certain rate. If I invest all and continue to deposit and invest it grows more…

    your thoughts please.

    • Lazy Man says:

      Yosef,

      I wrote this article many years ago. It turns out that Prosper returns weren’t that good for anyone back then. However, they’ve improved. Lending Club is also very good. I’m not making more than 10%, but I’m getting close to 7%, which is better than stocks have been performing over the last ten years.

      I don’t tend to view P2P lending in a cash flow sense anymore. I don’t think it is wise to pour much of your money in that area as I used to. You should think of it like investing in bonds.

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