My last post was the first in a two-part series about the cornucopia of alternative investments.  Mainstream investments like stocks and bonds can sometimes seem like stale white bread as compared to the wagon loads of fresh-baked alternative investments available to individual investors.  In today’s post, I’ll finish perusing the buffet of alternative investments by evaluating:

• Peer-to-peer lending
• Derivatives (swaps, forwards, futures, and options)
• Collectibles and art.

Like my last post, I’m going to resist a made-from-scratch evaluation of these three alternative investments.  Instead, I’ll use the four cornerstones of mindfulness (rationality, empiricism, humility, and patience) as a quick recipe to evaluate whether any of these are worth considering further.

Peer-to-Peer Lending

Peer-to-peer lending is a way for borrowers to get loans directly from individual lenders instead of from conventional lending sources like banks.  The individual lender is investing their money by loaning it to one or more borrowers who are contractually obligated to return the loan, plus interest, within a specified period.  So, peer-to-peer investing returns come entirely from the interest paid back on the loans.

Peer-to-peer lending dates back to at least the time of the Bible, which has several verses about loans between people, as well as from “banks”*.  Because it’s often difficult for individual investors to find reliable borrowers, banks and similar financial businesses have historically served as the link between people with money and those who need to borrow, while profiting handsomely from the exchange.

But the internet is slowly disrupting this long-standing intermediary function of the banks.  Peer-to-peer lending platforms sprung up in the early 2000s and have grown into a business that transacts $86 billion dollars in loans.  Unlike banks, peer-to-peer lending websites don’t make money from charging interest to borrowers; instead they charge fees on the facilitated transactions.  There are many peer-to-peer lending platforms that focus on different types of loans including:

• Personal loans for just about anything
• Personal loans to people with bad credit
• Loans to start or expand a business
• Loans for real estate investing
• Student loans
• Non-profit micro lending.

To avoid inadvertent recommendations, I won’t list any peer-to-peer lending companies.  You can find reviews of various platforms by using the Mindfully Investing Personal Finance Blog Search engine.  (I suggest searching for “peer-to-peer investing reviews” or something similar.)  I did a few searches of my own to find information on peer-to-peer returns and risks, which are the two key metrics for any investment.

Returns – I quickly found recent and credible accounts of investors obtaining anywhere from 2% to 11% annual returns from a few of the larger peer-to-peer lending platforms.  The platforms themselves report investor annual returns anywhere from “less than 0%” (losing money) to “greater than 15%”.  One popular platform reports the most common annual return for less risky portfolios as 6% to 9% and for more risky portfolios as 9% to 12%.

Given that the average annualized returns for stocks since 1871 is about 9.0%, a potential annual return in the 9% to 12% range sounds appealing.  But of course the devil is in the details.  To get those higher returns, you need to loan money to people who have a higher risk of defaulting (not paying you back).  And finding the right balance between a good return and reasonable default rates depends on the focus of each platform, how it’s operated, and many other details.

Further, I found results and commentary from peer-to-peer investors indicating that returns have declined substantially in the last few years.  For examples, Retire Before Dad reported his annual returns declining from 13.3% in 2014 to just 5.6% in 2019.  And Lend Academy reported returns of 12.4% in 2014 declining to as low as 4.5% in 2018.  Perhaps the days of plus 10% returns are over for peer-to-peer investing due to competition and other factors.

Risks – The major risk with peer-to-peer lending is defaults.  The main way peer-to-peer platforms reduce this risk is through diversification.  For example, instead of loaning your entire $10,000 investment to one person, most platforms suggest or require that you spread that money around to many borrowers.  For the borrowers, that means their loan is coming from a group of investors, and the interest paid back is split among that same group of investors.  The platform does all the work of making sure the correct amounts of money get into the right hands on both sides of the transaction.  So, if one borrower defaults, many investors take a small ding in their return, which greatly diminishes the risk of negative returns for any individual investor.  Some platforms also maintain reserves or insurance that they can use to minimize the impact of defaults on collective returns.

Of course, the return you get is highly dependent on the default rate within the group you’re lending to.  While all the platforms factor past defaults into future return estimates, the default rates are necessarily based on past data.  Given that most of these sites have existed for 10 years or less, the track record for these default rates is an order-of-magnitude less than the 147 and 94-year histories of U.S. stock and bond returns, respectively.  Past default rate estimates may be even less predictive of future rates because of changes in the economy or platform operating rules over the years.

I reviewed some personal anecdotes from various bloggers to get some sense of the potential divergence between expected return estimates and actual returns, which is one way to summarize default and other risks involved with peer-to-peer investing.  This table compiles the results.

Source	Report Date	Expected Annual Return Estimate	Actual Annualized Return
Money Under 30	Oct-2019	10.5%	5.1%
Passive Income M.D. (platform A)	Dec-2017	8.2%	5.2%
Passive Income M.D. (platform B)	Dec-2017	7.5%	2.9%
ESI Money	Jun-2017	7.3%	3.0%
Side Hustle Nation	Feb-2016	9.6%	12.4%
Retire Before Dad	Jan-2019	7.8% (est)	5.6%
PT Money	Jan-2019	6.2% (est)	5.5%

You’ll note that actual returns above 9% were pretty rare.  Excepting the oldest result, the actual returns were 1% to 5% lower than the investor originally expected.  Yikes!

Given that peer-to-peer lending is a relatively new industry, the potential for platforms to go out of business is another risk.  U.S. regulations require that platforms have a plan for resolving loans after a company “failure”.  But it seems unlikely that such plans insure zero impact on investor returns, considering all the unexpected issues and chaos normally associated with a large business dissolving.

In terms of both returns and risks, peer-to-peer investing is remarkably similar to high-yield corporate bond funds (often called “junk” bonds).  Like high-yield bond funds, peer-to-peer investing provides access to riskier high interest rates, while mitigating some of that risk through simultaneous exposure to many borrowers.  It’s not surprising that peer-to-peer returns are becoming more aligned with the prevailing interest rates for high-yield bond funds; both are around 5% to 6% per year or less.

Therefore, the mindful conclusion about peer-to-peer investing is like earlier Mindfully Investing conclusions about high-yield bonds.  Specifically, mindful investors should focus mostly on stocks.  To the extent your portfolio has some bonds to cushion against short-term stock declines, using high-yield bonds simply pushes your overall portfolio into a more risky profile that’s similar to holding more stocks instead.  Holding too much risky high-yield bonds, or peer-to-peer loans, starts to defeat the purpose of holding a combination of safer bonds and more risky stocks.

Derivatives

A derivative is a contract between parties where the value of the derivative is based upon an underlying asset or financial instrument such as stocks, bonds, commodities, currencies, or groups of such assets like an index.  The most common derivatives include a contractual agreement where parties:

• Swap – Exchange one cash flow from some underlying asset for another cash flow under specified conditions in a “non-standard” contract (a contract devised by the parties involved).
• Forward – Buy or sell an asset under a non-standard contract at a specified future time at a price agreed upon today.
• Future – Buy or sell an asset under a “standard” contract (a contract devised by an intermediary) at a price agreed upon today (the futures price) with delivery and payment occurring at a specified future date.
• Option – Give the buyer the right under a standard contract, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specified date.

These derivative types are often further sub-categorized by the underlying asset involved, how they pay off, and the manner in which they’re exchanged.  There are even more complex derivatives such as credit default swaps, which were a key factor in the 2008 financial crisis, and collateralized debt obligations, both of which are only distantly related to an underlying asset.  There are many more flavors of derivatives that I won’t attempt to describe here.  But if you’re interested in finding out more, Investopedia is a good place to start.

Derivatives are mostly used to manage investing risks.  Depending on which side of the derivative contract you’re on, you can use them to either decrease risks associated with the underlying asset (called a hedge) or take on more risk in the hopes of achieving a higher returns than would be available from investing directly in the underlying asset.

Returns – Because of the very nature of derivatives as a risk management tool, it’s impossible to generally characterize the returns available from derivatives.  Returns can vary from massive losses to theoretically astronomical positive returns.  The  returns are entirely dependent on the particulars of the obligations and rights under the derivative contract.

Risks – For the same reason, it’s impossible to generally characterize the risks from derivatives.  It’s easy to buy a future or an option that loses money.  But that’s not always a bad idea.  For example, you might end up losing a bit of money in return for insurance against losing a larger amount of money from exposure to an underlying asset.  It’s just like paying insurance premiums, even though your house didn’t burn down this year.  However, it’s safe to say that derivative risks usually involve:

• Value risk – In most cases it’s almost impossible to know a derivatives “true” value.  The risk here is uncertainty about how others will value that derivative now or in the future.
• Easy Leverage –  One or more parties involved in a derivative often use borrowed money (or leverage), which is relatively easy to obtain.  Putting up only one dollar for every 8 or 10 dollars in the contract is not unusual.  Easy access to leverage compounds the potential size of derivative losses.
• Time Restrictions – Most derivatives have a time component.  So, you can have the right investing thesis (e.g., oil prices will go up by 10%) but still lose money because your timing was wrong (e.g., oil prices went up a month after your contract expired).  Unlike long-term stock or bond investing, derivatives force you to engage more actively in market timing, which is essentially impossible with any consistency.

It’s certainly possible to make money through derivatives; it happens everyday.  But the complexities involved combined with the substantial risks of losing money brings me back to the same conclusion I had in my last post about obscure alternative investments.  Specifically, a rational and objective assessment suggests that acquiring the necessary expertise in one type of derivative or another involves a similar level of effort as starting a new business.  And this blog is primarily about investing your savings from your existing profession without having to moonlight on a second line of work.

Collectibles and Art

Judging from all the television shows about collectibles like Antiques Roadshow, American Pickers, Pawn Stars, and Storage Wars (to name but a few), people love the idea of making money on collectibles and art.  There are an amazing array of things you can buy that have the potential to appreciate in value over time.  Here’s a less than exhaustive list based on some quick internet research:

• Fine art paintings, lithographs, prints, photographs, sculpture etc.
• Pop, folk, tribal, and ancient art
• Jewelry and watches
• Stamps
• Coins
• Antique furniture, home furnishings, and decor
• Rare automobiles, motorcycles, and other transportation
• Rare arms and military memorabilia
• Comic books
• Baseball cards
• Rare toys and games
• Pop and sports memorabilia
• Rare books, manuscripts, maps, and historical documents
• Rare musical instruments
• Wine

While the television shows create hopes of finding that million dollar treasure collecting dust in the garage or attic, in the real world (as opposed to reality television) that almost never happens.  On the other hand, if you already have specialized knowledge through a hobby or interest such as collecting baseball cards or comic books, it’s certainly reasonable to buy collectibles as an investment.

Returns – Because of the diversity of things you can collect, it’s impossible to say what the “typical” returns on collectibles are.  And unlike the stock market, where you can get a price quote in any given minute, collectibles are exchanged in much more esoteric and location-specific ways.  So, determining a fair value for collectibles is often extremely difficult.  The value is often entirely in the eye of the potential buyer.  The only safe generalization is that, the more knowledge you have about an item, or can buy from an expert, the greater the potential returns.  And the less knowledge you have, the less likely you’ll make a decent return.  Further, costs eat into returns, and the costs associated with investing in collectibles and art are generally higher than for mainstream investments.  Collectible investing costs can include research time, broker fees, expert help, appraisals, insurance, marketing, maintenance, restoration, and storage.

Risks – Given the esoteric nature of collectible and art markets, the values of most of these items are much more volatile than stocks.  Because of changing trends in tastes, styles, and interests, things that were once highly prized can become quickly worthless and vice versa.  Additional risks for collectibles and art include:

• Illiquid – Collectibles and art may have an expected value only at certain times, places, or when you can find a particular kind of buyer.  It may take a long time before the perceived value is realized with a sale.
• Counterfeits/Fraud – Imitations and misrepresentations exist for almost all types of collectibles and art, and some are very hard to detect.
• Condition/Loss – Value is highly dependent on condition, and flaws or wear that seems unremarkable to you can greatly impact value.  And of course the value of all your collectibles could be wiped out in one basement flood, unless you buy insurance, which eats into your returns.

For most of us, collecting fine art or expensive antiques is financially impossible.  So, it’s also worth noting that collectible and art funds have sprung up in recent years.  These private funds are purportedly run by experts that buy and sell the physical collectibles or art.  By investing in one of these private funds, you are essentially owning a small piece of many pieces of art.  As compared to owning stock funds, art and collectible funds costs are often excessive, such as 1% to 3% in annual management fees plus a 20% cut of all profits.

Taxes

Before investing in any of these three alternative investments, be aware that the tax rates on profits are different than stock long-term capital gains and qualified dividends, which are most commonly taxed at a rate of 15%.

• Peer-to-Peer Lending – The IRS taxes interest payments as ordinary income.  So, most people will pay more tax on this income than they would on long-term stock capital gains and qualified dividends.
• Derivatives – Tax regulations are different for each type of derivative and are byzantine as compared to stock and bond regulations.  So, you might pay more or less tax on your options or futures profits as compared to stock capital gains and dividends, depending on the situation.
• Collectibles and Art – The IRS taxes profits from sales of collectibles or art held more than one year at a relatively high rate of 28%.

Conclusions

In my last post on alternative investments, I summarized the conclusions for each type of investment on a mindfulness scale from 1 (least mindful) to 10 (most mindful).  Here’s the same summary for the three alternative investments discussed above:

• Peer-to-Peer Lending – Has a current return that is similar to or less than the expected return for stocks.  The risks are like diversifying a portfolio with high-yield bonds, but peer-to-peer lending has some added risks due to the newness of this business model.  Mindfulness score = 3
• Derivatives – Have the potential for huge rewards and huge losses.  Your potential success with derivatives is largely dependent on your willingness to spend large amounts of time and energy becoming an expert in one of these derivatives.  It also requires a fair amount of luck because derivatives require market timing decisions.  Mindfulness score = 1
• Collectibles and Art – Have unpredictable potential returns and losses that are also highly dependent on your knowledge in one of these areas.  If you already have an interest in one of these areas, or think you might enjoy learning more, collectibles or art may be a reasonable form of portfolio diversification.  But it certainly seems unwise to concentrate too much investing capital in one of these esoteric markets.  Mindfulness score = 2.

Like my conclusions for annuities, commodities, currencies in my last post, it’s pretty clear that your investing diet shouldn’t contain too much peer-to-peer lending, derivatives, or collectibles and art.  To the extent you think it could be fun to devote the time needed to successfully invest in peer-to-peer lending or collectibles and art, it might make sense to devote 5% or 10% of your investing capital in one of these areas.   In contrast, derivatives seem like empty calories that are mainly just risky to your investing health.

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* The original meanings and later translations of this word are interesting, as discussed here.