Diversification is essential to success on Prosper. There are many kinds of diversification: multiple loans, geographic, loan use… While the most important kind of diversification is accomplished via as many as loans as possible (no more than 2% of your portfolio in a single loan), the type of diversification that often gets over looked is credit grade diversification.
On Prosper borrowers can have a ScoreXPlus score of 520-800. The higher end is safer, it also offers reduced rates. Conversely, the lower end of the spectrum is very risky and offers high rates. By mixing your credit grades you can achieve greater return with reduced risk.
At the moment I am only comfortable (I believe they are profitable) with the credit grades AA-D (no E, no HR).
One could either choose a straight line diversification (similar to mine only I am AA-C straight line with some D) or some kind of weighted diversification.
I think everyone understands straight line diversification… You put equal portions of your portfolio into each credit grade. This achieves an equal blend of both the risk and rate from each credit grade.
If you are more risk averse you might choose an unequal weighting towards the higher credit grades. One way to do this would be to use a Fibonacci sequence.
Fibonacci starts: 1, 1, 2, 3, 5. Applied to our example, the loan by credit grade proportions are 1D to 1C to 2B to 3A to 5AA. A portfolio weighted in such a manner would be less risky than the previous example and still provide higher rates.
What do you think? How else might you weight the portfolio?
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