Just the other day, a friend came to me with a serious and specific question.
He’s been watching the markets, and the headlines, and wanted to know if he should “sell everything and go to cash.”
I laughed and asked: “Do you know something I don’t? Do you know, for sure, that the sky is falling?”
He doesn’t, of course. But I could tell from his comments that he was worried about several things – that China was about to implode, or could in the near future – and that he wanted to protect his investments.
Without missing a beat, I suggested he just “short” China and make a ton if it crashes.
This wasn’t an off-the-cuff quip. Investors who’ve followed me for a long time know that one of my core beliefs – a mantra, really – is that there’s always a place and a way to make money.
I believe you can find ways to make money in any kind of market – bull, bear or trendless. And I believe that because you can make money on both “sides” of the market – the long side and the short side.
That’s why I love trading and investing. It’s possible to make money when something… anything… everything… goes up.
And it’s also possible to make money when something… anything… everything… goes down.
That understanding is a big part of the reason I’ve been so successful through the years.
Today I want to share that insight with you…
Three Keys to the Market’s “Other Side”
Unfortunately, most people don’t know how to make money on both sides of the market.
Everybody knows that if you own stocks, bonds, commodities, gold or real estate – or any asset in any asset-class for that matter – you make money as long as prices are rising.
But asset prices don’t rise forever.
Sometimes prices dip down. Sometimes they crash. Sometimes they recover quickly, sometimes they recover slowly and sometimes they never recover.
You can make money in any market if you know that nothing goes up forever. With that understanding, you’ll not only avoid big losses when prices drop – but can actually make a ton of money when that happens.
It’s not hard. There are lots of ways to make money when things go down. And you don’t even need to know them all.
In fact, you just need to understand the three most popular ways to play price or market declines. Those three key strategies are:
Selling short, more commonly known as “shorting.”
Buying “put” options.
And buying “inverse” exchange-traded funds (ETFs).
Today I’m going to tell you about shorting. In some upcoming columns, I’ll explain put options and the inverse ETFs.
On Wall Street, the term for owning something is “being long.” If you own shares of International Business Machines Corp. (NYSE: IBM), then you are “long” Big Blue.
If you own gold (it doesn’t matter if you own gold bars or a gold stock) and I come to you and ask, “Do you like gold?”… then you could say, “Yes, in fact, I’m long gold.”
That tells me you own some gold.
The opposite of long is short. The opposite of being long something is being short on that same asset.
That’s where the terms “short selling,”“selling short” and “shorting” all come from. They all convey the same thing – the opposite of “going long,” or “being long.”
Instead of buying and going long on an asset – in essence, betting the price will go higher – you can short that asset and bet the price will go lower.
It’s really simple. You either tell your broker you want to short XYZ stock or look on your trading platform (online broker) and find the button or link for shorting.
The process, for the most part, is as simple as buying a stock.
A Step-by-Step Look
Here’s what happens behind the scenes.
When you sell a stock short, you are selling that stock to someone who is buying it from you.
However, you don’t actually “own” the stock that you’re selling.
Let’s say XYZ just ran from $50 to $100 a share. And you want to short it because you believe some developing news about the company – for instance, bad earnings or a nagging legal case that won’t go away – will spur profit-taking and cause the stock to fall back to $50.
When you short-sell the stock, you are actually selling it to someone. The person who buys the stock from you pays you $100 each for all the shares you sell them. He doesn’t know you don’t own the stock you’re selling – and he doesn’t care. All he knows is that he has to pay for the stock he bought and he wants the shares to go into his account.
Behind the scenes, to get you the XYZ shares that you’re selling, your brokerage “borrows” them from another person’s account. Your brokerage delivers those shares to the buyer, and now you’re done with her.
You end up with the cash – the $100 a share – in your account.
Now you are “short XYZ” at $100 a share.
If you’re right and XYZ falls to $50 – and you want to get out of the short position to lock in your profit – you would buy shares of XYZ. When you buy back shares you’ve shorted, it’s called “covering” or “buying to cover.”
So, you “cover” your short by paying $50 for XYZ stock. You pay $50 out of your account, and the seller has to deliver XYZ shares to your account. Now you have XYZ shares in your account.
But you owe someone shares of XYZ that your brokerage borrowed on your behalf.
You don’t have to do anything. Your brokerage knows whom it borrowed those shares from. The broker simply take the shares you just bought out of your account and places them back into the person’s account the shares were first borrowed from.
This behind-the-scenes maneuvering is completely permissible.
Your brokerage agreement – everyone’s brokerage agreement, in fact – allows your broker to borrow shares from your account any time it wants. It never has to tell you. You’ll never know. And it doesn’t matter to you.
The only thing that matters to you – or anyone else – is that when you go to sell the shares in your account they are there. If you sell shares from your account that your brokerage already lent out to someone, it doesn’t matter: The broker will simply borrow them from someone else’s account so you can deliver them to whoever buys them from you.
But here’s the complete picture of what happened financially – for you.
You started by selling stock for $100. You got that cash in your account. You’re up $100, out of thin air. But once the stock drops, as you predicted it would, you had to use $50 to buy back the shares you borrowed to start this all off.
So you received $100 a share at the outset – when you shorted the stock. And you paid $50 a share when you “covered.” So you ended up with a net total of $50 a share in your account.
You just made $50 a share – from a stock that went down.
A Look Ahead
There is one big difference between going long and going short.
I’m talking about the risk.
When you’re short a stock, you are expecting it to fall in price.
But what if, instead, it goes up? If that happens, you have to buy the stock back – cover it – at a price higher than what you sold it for.
If XYZ didn’t go down – but jumped up to $150 – to get out of the position (cover), you would have to pay $150 a share.
Here’s how the math would work in this situation.
When you shorted XYZ at $100 a share, you initially received $100 in your account. But with the stock now at $150 a share, you’d now have to come up with $150 to “cover” – to buy it back.
So you lose $50 a share.
When you go long on a stock – buy it – your potential loss is limited to the amount you invested… what you paid for the stock. In other words, when you buy a stock and it goes down, your loss is said to be “limited” because the stock can only go to zero – and no lower. That’s comforting.
Theoretically, selling short leaves you with unlimited risk. That’s because a stock can keep going higher and higher. As with any risk, however, there are ways to manage this.
That’s your quick lesson on shorting.
It’s a quick lesson because I’m not going into “margin” – using borrowed money for “leverage” – and how you need a margin account and what brokerages charge you for margin. If you have any questions on that topic, ask your broker. You can ask him or her how that works and what the firm’s charges are. Or you can read the account agreement the brokerage made you sign.
And if you have any questions about the topic of shorting, send them in right here. I’ll answer them.
I’ll also tell you what’s going on with China and why my friend is worried that the Chinese stock market could tank and knock down U.S. and global stock markets.
And I’ll tell you how to use put options and inverse ETFs to make money when things go down.
The financial markets bring us lots of opportunities for profit – and not all of them are on the long side.
I look at everything.
And that’s why I believe there’s always a place to make money.
[Editor’s Note: As Shah said here today, he looks forward to your comments and questions. The process is simple – you can just post the below.]
It’s a great day when a mega-profitable industry that sucks money out of us for services we can’t live without has to change how it lines its pockets.
And that day has come for insurance companies.
We’ve been talking at length about the new economic disruptors that are forcing change in everything from public policy to the financial markets.
And even the powerful insurance carriers aren’t immune.
Thanks to these Disruptors, you can you bring down your cost of health and auto insurance – benefitting the consumer side of your personal ledger.
You can also bolster the investment side of your ledger: Disruptors are upending the insurance industry, meaning you can make money by betting against insurance dinosaurs whose business models are under attack.
Let me show you what I mean…
In the good old days for insurance companies, auto and health insurers lumped all their customers together. If you were a good driver, you paid virtually the same rates as bad drivers. If you exercised and ate right, you still paid the same health-insurance rates as fast food-eating chain smokers.
The reasoning is simple to explain. Insurance is about pooling risk and the dynamic of imperfect information – meaning that, as long as customers don’t know how to assess what kind of risk they represent to an insurer, they can’t negotiate the price they pay.
Insurers pool good drivers and healthy people with high-risk policyholders so that there will be enough money to pay claims – and still profit handsomely.
In 2014, U.S. insurance companies earned approximately $338 billion in profits.
But that’s all changing.
For a while, insurers have offered better rates based on an insured customer’s good driving record or good health history. Still, history takes time to develop, so rates haven’t come down that much.
That’s because smart devices, smartphones and wearables are changing the information-gathering dynamics and forcing providers to distinguish between low- and high-risk customers.
Auto insurers are already offering discounts and safe-driving rewards based on “dongle” devices an insured motorist can plug into a portal behind the dash of most new cars.
Progressive Corp. (NYSE: PGR) – known for its hugely popular fictional pitchwoman “Flo” (actress Stephanie Courtney) – also advertises Snapshot (a dongle device) in the company’s many TV and radio ads.
According to Autoblog.com, “Progressive uses these devices as part of its Snapshot usage-based insurance program, which has been around since 2008. The dongle, which plugs into the OBD-II diagnostic port, collects data on how many miles are driven, what times of day a vehicle is in operation and how hard a driver brakes. In exchange for this driver data, prudent drivers can receive discounts as large as 30% off their premiums.”
Allstate Corp. (NYSE: ALL) offers its customers Drivewise. According to Compare.com, “Drivewise tracks your driving habits via a mobile app or a small device installed in your car and then sends the data to Allstate. You can look at the data collected on Allstate’s website, so you can analyze your own driving habits to look for problem areas and see how much you’re saving. Allstate says Drivewise will not increase your rates, and could help you save up to 30% on your premiums.”
Check with your auto-insurance provider and see if it has a device that can earn you discounts. If you decide to make that request, be sure to also ask about the cybersecurity on the devices and if the device can be hacked. Someone could remotely take over your car. (And I’m not kidding.)
Unhealthy Health Giants
The health-insurance industry is facing even greater disruptions from new technologies than its auto-insurer counterparts.
As I hinted earlier this week in my column on healthcare Disruptors, wearable devices are changing the landscape in medicine. And that includes changes with insurance costs and practices.
Dr. Benno Keller, head of research and policy development at Zurich Insurance Group Ltd. (OTC ADR: ZURVY), recently said that “this interaction with technology will inevitably generate an enormous of data about the wearer’s choices and lifestyle which insurers can use to refine their understanding of the risks faced by their customers. It would make it easier to predict outcomes and even push solutions to challenges that have yet to occur.”
Insurance giants UnitedHealth Group Inc. (NYSE: UNH), Humana Inc. (NYSE: HUM), Cigna Corp. (NYSE: CIG) and Highmark Inc. are creating programs to integrate wearables into policy pricing and care dynamics.
Companies like energy heavyweight BP PLC (NYSE ADR: BP) are encouraging their global employees to sign up for programs that use wearables to track the number of steps they take, how long they sit and other activity measures to get them healthier so they can lower the cost of insurance they charge them through company-coverage policies.
Time’s Running Out on Insurance Giants
The soon-to-be released Apple Inc. (Nasdaq: AAPL) Apple Watch may single-handedly change the face of insurance.
Some of the things the Apple Watch will track include your heart rate, blood pressure, hydration and blood sugar. It will count your steps, monitor your sleep, measure how much sunlight you get and remind you about your weight. Everything the smartwatch will be able to do, in terms of monitoring your health, can be transmitted to insurance companies and provider servicing databases to better profile what kind of risk you pose to the insurance company.
If you want to save money on your health insurance, you’ll be able to do so – if you don’t mind sharing your personal metrics with your provider.
How much might you be able to save? In due course, a lot.
That’s because there are already startup insurance companies like Oscar – “Disruptor” companies – that are attacking the old insurance model to bring down premium costs for policyholders who demonstrate they are low-risk customers.
Late last year, in fact, Fortune described New York-based Oscar as a “hipster health insurance company” and a “web-savvy startup” – just the kind of Disruptor to take on the entrenched giants.
As these disruptions take hold, you are going to be better equipped to improve your own health with wearables.
You are going to be able to negotiate down what you pay in premiums for your insurance.
And, if you stay tuned here, I’ll tell you who the new Disruptors are that will be worth investing in – like the privately held Oscar, when it finally goes public.
And I’ll also spotlight which giant insurers are going to end up being burdened with bad risks, faltering profits and falling share prices.
And some of those could end up as “short” candidates – underscoring the fact that Disruptors create profit opportunities on both sides of a trade.
[Editor’s Note: Shah wants to hear from you. If you have questions or comments, please feel free to post them below.]
Remember the May 2010 “FlashCrash,” when the Dow Jones Industrial Average dropped more than 1,000 points in one day? Now, the British high-frequency trader who stands accused of contributing to the crash, NavinderSinghSarao, is fighting the U.S. extradition.
Should this sort of trading be illegal – or is the system the real problem? In his most recent Fox Business appearance, Shah revealed some of the bigger truths about high-frequency trading and answered even more of your biggest questions.
Someone I love very much – in fact, a family member I idolize – was recently diagnosed with Parkinson’s disease. We are all in shock, and some members of my family are very frightened.
But I made a decision. Instead of being frightened, I’m going on the attack. As transformational thinking lecturer (and “Est” founder) Werner Hans Erhard advocates, I’m going to be “cause in the matter.”
So I’ve given myself a mission… to do my part to help find a cure.
And it’s an opportune time…
Major diseases like Parkinson’s, Alzheimer’s and diabetes have a new enemy: research initiatives that attack them from fantastic new angles – yielding new protocols and medicines that can stop these maladies in their tracks or even reverse their chilling effects.
I’m not talking about “old school” drug protocols or research. I’m referring to the new healthcare and research Disruptors that I’ve been watching – and that are everywhere.
A powerful confluence of catalysts is making this possible, including new science, new technologies and even new policies at the U.S. Food and Drug Administration (FDA) – such as a groundbreaking “Fast Track” designation that slashes the time it takes to get new drugs into the hands of the patients who need them.
My resolve to help fight Parkinson’s – as well as the other terrible diseases I mentioned – has already gained me access to some rarefied circles. I’ve been asked to join the board of an extraordinary company whose partnering doctors head up the research units in their respective medical specialties at the top hospitals in the United States.
I’m also helping raise money for research – which includes making contributions myself.
The doctors I’m backing are leaning into the future in a big way. The head of the research-and-development company I’m involved with previously ran a giant pharmaceutical company. He’s now attacking the diseases his old pharma company treated with drugs by developing completely new protocols to stop diseases from spreading and eventually reverse the damage that they do.
I’m not permitted to reveal the name of the company I’m working with just yet.
But I will make this promise: Over time – as we crusade toward our goals of arresting the spread of the diseases we’re attacking and advance development of reversal protocols – I will be able to share some of what we’re learning, how trials are going and how our success will benefit everyone.
Eventually, there may even be ways for you or your loved ones to get into trials (we’re not there yet, but getting closer) by participating directly through new healthcare Disruptor tools like iPads and iPhones.
Meanwhile, we can invest in the Disruptor players, a move that will have dual benefits. It will not only aid the eventual defeat of these dreaded diseases, but it will allow us to profit from the full-frontal assault on them.
And that’s what we’re going to start looking at today…
A True “Game-Changer”
As you probably gleaned from my reference to iPhones and iPads, Apple Inc. (Nasdaq: AAPL) is a focus of interest for me – a true Disruptor company whose muscle is changing an array of sectors, markets and disciplines.
The Cupertino, Calif.-based company and its stock obviously benefits from heavy analyst and media coverage – some might even say over-coverage.
Even so, because of the way I’m looking at this, you’re in for a beautiful awakening.
Tim Cook, Apple’s brilliant and visionary chief executive officer, recently appeared on Jim Cramer’sCNBCMad Money‘s 10th anniversary show, where he discussed the impact of the soon-to-ship Apple Watch on medical research through the company’s ResearchKit open-source software framework. He told Cramer that the effect “has been so strong that, within the first 24 hours of announcing the ResearchKit, some 11,000 people signed up for a study in cardiovascular disease through Stanford University.”
In fact, Cook told Cramer “it would typically have taken 50 medical centers an entire year to sign up that many people.”
Here’s an example.
In a ResearchKit case study, Kathryn H. Schmitz, professor of epidemiology in biostatistics at the University of Pennsylvania’s Perelman School of Medicine, recounted how they mailed printed fliers to 60,000 women and got only 305 to reply and sign up for a research project. She calls ResearchKit and Apple’s related HealthKit a “game-changer.”
And the disruptions don’t stop there.
Just on April 13, International Business Machines Corp. (NYSE: IBM) announced a far-reaching new partnership with Apple. IBM is linking its HIPAA-enabled Watson Health Cloud up with Apple’s HealthKit and ResearchKit. In conjunction with additional partners Johnson & Johnson (NYSE: JNJ) and Medtronic PLC (NYSE: MDT), IBM and Apple will develop “enterprise wellness apps” made possible by the merged medical and health data gleaned from Apple devices. Watson’s job will be to facilitate data-mining and provide predictive analytics.
The University of Rochester and Seattle nonprofit Sage Bionetworks are also working together to create the Parkinson’s research app, mPower, using Apple’s ResearchKit.
According to Sage, “mPower aims to make it easier for people to sign up for studies and providing consent to do so. The app can detect symptoms in Parkinson’s patients just by having them say ‘ahhhh’ into the phone. It also includes a finger-tapping feature that can detect symptoms, too. Finally, the app can analyze the user’s gait and balance by having them walk 20 steps then turn around and take 20 steps back.”
(If you want to check this out, this link will take you to Sage – where you can find out more about mPower and possibly get into its research program.)
The Next Sector to Be Upended
As far as making money as you help with the assault on these terrible diseases, one way is owning Apple stock. Because of the “ecosystem” it is creating, Apple’s long-term financial health is, by design, tethered to the future health of the world.
That’s big, and it’s going to make Apple one of the world’s most critical companies. In turn, the company will become even more profitable and a fantastic long-term investment for decades to come.
While Apple is the first investment idea I love because it is a healthcare Disruptor in every sense of the word, I’m following others, too.
You’ll be reading about them here for some time to come.
But I’m not done with explaining how Apple’s products are “cause-in-the-matter” Disruptors.
I know of at least one other industry – not healthcare, but related – the new Apple Watch is going to disrupt. It’s an industry you never imagined would ever change. And there’s going to be money to be made there, too.
I’ll tell you what that industry is later this week.
In the interim, however, I will give you a hint – so see if you can guess what it is.
The hint: This industry is both hated and loved. It’s hated, because it costs us a lot of money. It’s loved, by some, because it saves us a fortune.
[Editor’s Note: Shah welcomes your questions and comments. Feel free to post them below.]
Shah says absolutely not. “All the bad news isn’t out yet,” Shah said yesterday on FoxBusiness. With the threat of a multibillion-dollar antitrust fine in Europe, Shah warned viewers that a tough road is still ahead for Google Inc. (Nasdaq: GOOG).
But that’s not all he shared with Varney & Co. viewers. With tax season now behind us, host Stuart Varney asked one of those questions on everyone’s minds right now: Should taxation be considered grand theft? Just view the video below to see how Shah answered that one…
The new lending Disruptors are marching – make that rampaging – over the traditional fields and fortifications once commanded by banks.
Today I’m bringing you further proof of the powerful changes these Disruptors are driving, as well as the opportunities they are creating. And I’m also answering some pretty good questions readers posed in response to our recent reports on Lending Disruptors.
(By the way, we’re certainly not done talking about those Lending Disruptors. I’m going to come back on this subject with a few killer stock opportunities for us to play and profit from. But it’s time to move on to the next giant Disruptor that’s going to make us money. And the next Wall Street Insights & Indictments report will impact you, your wallet and even your health, so be sure to stay tuned.)
Today, however, let’s take one last careful look at Lending Disruptors.
It’ll be well worth your while…
A Special Tax Tip
Earlier this week, in American Banker, I came across an article by Nick Clements. He knows the credit card business inside-out, having previously served as the managing director of the consumer credit card business at Barclays PLC (NYSE ADR: BCS). And his sentiments echo exactly what I’ve been telling you about the new Lending Disruptors.
“On the West Coast, a crop of startups without legacy earnings to protect are looking to disrupt an industry that has thus far failed to give consumers the value they deserve,” Clements wrote. “Companies like SoFi, LendingClub and Payoff are offering loans with much lower interest rates than credit cards. In addition to lower rates, these companies are providing customers with a much more transparent product, thanks to the simplicity of a personal loan.”
An attack on the credit-card business is a frontal assault on every big bank’s most lucrative line of business – credit-card lending. Among all the “traditional” lending activities banks engage in, credit cards generate huge, consistent revenue streams, have the fattest profit margins and are major contributors to a bank’s bottom line.
The moat that for so long protected banks’ business lines and profitability is being filled in quickly by the new lenders – and there’s no turning back.
Now here are a couple of great questions that readers wanted answered, which I’m all too happy to do in order to help make it easier for you all to make money
Do the business-development companies (BDCs) you recommend issue a K-1 form to shareholders for tax reporting? I’m interested in the income from these BDCs, but the shareholder must anticipate the lateness of the issue of the K-1 and know to hold off filing taxes until the last minute so the report can be included in the tax filing.
Yes Jerry, BDCs do issue a K-1 for tax-filing purposes. Ideally you would receive this at the end of February or beginning of March. However, some BDCs have been known to issue late these in the tax season, causing you to have to file an extension. Therefore, this should definitely be a consideration when investing in these vehicles.
Thank you for your informative report. I’ve known about BDCs: But are they like “master limited partnerships” (MLPs), where you need to invest a lot of money – like $10,000 in each company – because of tax requirements?
My tax preparer told me to get out of MLPs, because I did not invest large amounts of money, and I was paying through the nose to my tax preparer, because of the extra paperwork that is entailed on the preparer’s end.
That’s one point that is not addressed in any of the newsletters I have read. Investors are encouraged to get into MLPs – because they have to pass their profits on to the investor (90%) in the form of dividends. But when you only invest small amounts, it amounts to pennies you get back. So unless you have $10,000 to invest in them, it’s not worth the effort. Does the same principle apply to BDCs? It is an important factor when making decisions about investing in a trade.
I appreciate all that you do to help us – even the little investors. You are a gem!
Really good question, Mary. Because BDC distributions are subject to more complex tax treatment than ordinary dividends, there will be some extra work on the part of your tax preparer. What you receive from the BDC is broken down and taxed as four different kinds of distributions: income, qualified dividends, non-qualified dividends and return of capital. The extra work for your tax preparer may be prohibitively expensive, and you should leverage this cost against any other “extraordinary” kinds of preparation he or she is already doing for you.
Thanks for the comments and questions: As you can see from today’s report, I follow them closely. In fact, I encourage you all to keep them coming. You can post them below.
And be sure to check in next week when we delve into the next big Disruptor opportunity.
We’ve been talking here for the past two weeks about peer-to-peer lending – or P2P lending, as it is known – and have given you several ways to cash in on these new Lending Disruptors.
And if you’ve acted on our recommendations, you’re already making money.
In myApril 6 report on the New Lenders, I recommendedGoldman Sachs BDC Inc. (NYSE: GSBD) and Apollo Management Corp. (Nasdaq: AINV).
GSBD, which yields more than 8%, popped at the open of trading Monday. At its high price Monday morning, you were up almost 10% from where I recommended it only six trading days ago (an annualized gain of nearly 2,600%). And just two days after we told you about it, the widely read Investor’s Business Daily highlighted the Goldman business-development entity as one of two recent initial-public-offering (IPO) stocks “notable for their eye-catching earnings and sales growth in recent quarters.”
Triple-digit sales and profit gains is part of what caught my eye.
As for Apollo Management – it’s roughly flat from where I recommended it. But the stock has a juicy yield approaching 11%, which means you’re ahead of the game even before it delivers the gains I’m predicting.
The bottom line: Stick with these two investments. They’ll rise nicely in due course. In the meantime, you’re getting a better risk-adjusted yield than you’ll find in most other places.
That brings me to the market intelligence I want to share with you today.
Most of our talks here focus on opportunities – places and ways to make money.
But successful investing also involves managing risk – minimizing the losses you incur… or avoiding them altogether.
Thanks to Disruptors like Goldmanand Apollo, the new lending market is one of the sexiest profit opportunities in the finance arena.
But what you don’t know can hurt you.
So today I’m going to show you how to avoid losing money in the shifting lending market…
They’re increasingly “investing” on (that’s “on,” not “in“) P2P lending sites like the one operated by LendingClub Corp. (NYSE: LC), a publicly traded firm, and Prosper, a privately owned Disruptor site.
On both the LendingClub and Prosper sites, investors fund borrowers looking for loans. You can see on the sites what borrowers want money for. They are all personal loans, mostly for such things as consolidating high-interest-rate credit-card debt.
The interest rates that the “lenders” (investors) earn are based on each borrower’s creditworthiness, as measured by new Disruptor credit calculation metrics and algorithms meant to be predictive of a borrower’s likelihood to repay their debts, as well as on the term (length) of the loan. Terms vary, but most are three-year (36-month) and five-year (60-month) loans.
If you’re considering funding a stranger’s loan request – because the interest rate being dangled is attractive to you – here’s what you need to know…
About Those Enticing “Interest Rates”
I said earlier that what you don’t know can hurt you.
Here’s where that warning comes home to roost.
You see, the posted rates aren’t really what you get.
And you’re funding someone’s personal loan – someone who can default and not pay you back.
About those rates.
First of all, you’ve got to pay a “service fee” to the site operator. Typically platform operators charge lenders 1% of every payment they collect from the borrower and pass the money through to the lending investor. So right away, knock off one percentage point from the posted rate the borrower is paying and that you think you’re getting.
Second – and more important – the borrower can default, meaning he or she stops making payments.
Because you’ve made a loan to that person, you’re screwed – as in, you’re not netting the interest you expected to earn on your money. And because these loans are unsecured, you may not get back the money you lent – as in never.
Here’s a good way to look at defaults and how to figure your real risk.
LendingClub and Prosper have to declare all their transactions in U.S. Securities and Exchange Commission (SEC) filings. So the data is there.
LendingClub’s 2007-2014 average interest rate paid by borrowers was 12.533%. The average default rate per year for the same period was 6.9%. Default rates plummeted from 14.81% in 2007 to 2.38% in 2014. And although the return on investment (ROI) was (3.44%) – a loss – in 2007 and rose handsomely to 9.61% in 2014, the average ROI over the period was just 4.587%.
The average interest rate borrowers paid on Prosper from 2009 through 2014 was a whopping 17.945%. The default rate over the same period averaged 7.18%. And the average ROI for the period was 9.68%.
But there’s more to numbers than digits on a page. For one thing, both platforms changed their borrower credit requirements – mostly easing them as the economic cycle moved away from the Great Recession and as unemployment, a key factor in their repayment metrics, dropped.
Interest charges over the respective periods changed, too.
To better understand the available numbers, or the ones you calculate yourself (as I did), you have to further “look through” them to better understand what they’re telling you.
There’s a lot more to the statistics.
And, on some levels, there’s also less.
These stats are for three-year term loans over the period we’re talking about.
That means the 2007 vintage loans were closed out by 2010. Most of the 2012 loans are winding down (depending on the month they began). That means some of the 2012 loans – and their successors from 2013 and 2014 – are technically not “completed.”
The takeaway: The final default rate tally isn’t available and won’t be for years to come on some of the loans.
And that changes the real numbers.
If you use the data of completed loans for three-year and five-year loans (for which there is a lot less data), the average default rate for three-year loans might be about 5% and for five-year loans about 10%.
Matt Burton, CEO of Orchard Platform, a New York firm that works with mostly institutional lenders on P2P sites, says that “performance can vary significantly, though returns have typically ranged from 6% to 7.5% over the past three years across all LendingClub and Prosper loans, net of fees and defaults.”
Burton’s right. And that’s just what I’m talking about.
The returns sound good, but because the more recent loans are largely not completed, the whole game has yet to be played. A downturn in the economy and a jump in unemployment could cause the default rates to balloon, blowing the results apart.
This is the definition of real risk. Unless you’re going to be really, really diversified -meaning you fund lots of loans in equal increments – or devise your own diversification modeling program, you’re more exposed to risk than you realize.
It only takes one default on the one loan you fund to wipe out your entire investment, net of any interest you may have received.
So be careful – very careful. If you like the nice fat yields you see on the lending sites, remember you need to engage in some risk-adjusting calculations to see if the return you hope to get is worth the risk of not getting your whole investment returned or “Not Completed.”
That’s why I recommended you invest in some of the players – instead of becoming one yourself.
[Editor’s Note: Shah appreciates the big response he’s received for his recent reports on “Disruptor” investments and will be addressing some of your questions. Keep the comments and queries coming. Just post them in the comment box below.]
In our talks here over the last week or so, we’ve been focusing our attention on so-called “Disruptors” – the catalysts of change that are impacting everything we do.
And one particular point that I made underscores just how wide-ranging these Disruptor-driven changes really are.
As I told you all last week, Disruptors are already changing how we communicate (smartphones), how we date (Match.com, eHarmony), how we mate (Tinder… or so I’ve heard), what we eat (genetically modified and so-called “super foods”), how we work (Monster.com, Jobr), how we get heat, cooling and light (fracking), how we get around (Uber and Tesla), how we get where we’re going (GPS) – and where we stay once we get there (Airbnb).
And tucked behind each one of these changes is a major opportunity to make money – and often an opportunity to turn life to your own advantage.
Here’s just such an opportunity: In the area of lending and borrowing, there are ways to “fix” your credit – or to develop a credit score if you’ve never had one.
And that’s the Disruptor secret I’m going to share with you today…
Forewarned Is Forearmed
One of the new developments in this slice of the credit market is this: New credit-scoring companies now provide nontraditional, credit-related data models to lending Disruptors. They’re also selling their new credit-scoring methodologies to traditional lenders – like banks.
Because lending Disruptors increasingly rely on new credit-scoring metrics to make loans easier and faster to get, established credit-scorers, like Fair Isaac Corp. (NYSE: FICO) – better known as FICO – are being forced to develop new scoring systems. That’s so their bank, mortgage and auto finance clients can compete with the “new” vanguard of credit-market players that are turning the lending market on its head.
These are the players we refer to as the “Lending Disruptors.”
What you need to understand is that many things you previously disregarded, or viewed as irrelevant, now matter a great deal.
In fact, the old maxim “It’s what you don’t know that can hurt you most” really applies here: These days, not knowing what increasingly will be used to calculate creditworthiness – the “new credit scores” – can lead to a self-inflicted borrowing wound.
In the good old days (or bad old days, depending on your perspective), credit scores were almost entirely based on such metrics as how much credit-card debt you had and your record of repayment, how you financed your car or education, your track record with your mortgage, and whether or not you had a tendency to make debt payments late or skipped them altogether.
Banks and traditional lenders mostly rely on FICO consumer credit risk scores as the most important metric in a consumer’s creditworthiness toolbox. That’s because FICO scores reflect loan amounts and payment histories on credit cards, mortgages, cars, student loans and personal borrowings – data that’s all submitted to, and modeled by, FICO.
The Game Changers
In the “traditional” market, FICO is pervasive: Fully 90% of U.S. banks in the United States make loan decisions using this credit scoring system.
But that’s changing.
New credit-scoring companies like VantageScore – a joint venture of credit bureaus Experian PLC (OTC ADR: EXPGY), EquifaxInc. (NYSE: EFX) and TransUnion Corp. – and Revolution Credit are changing the “inputs” used in ratings-systems models and presenting traditional lenders with new credit-scoring tools.
According to American Banker, VantageScore uses “so-called alternative data to evaluate consumers who cannot be scored using traditional criteria like timely credit card payments.” And RevolutionCredit “offers an alternative based on financial education. Consumers who sign up for the service – usually at the recommendation of their banks – are put through a series of online courses and tests on financial topics, the idea being that they will be more creditworthy once they complete the series.”
Nowadays, Big Data pipes deliver payment histories. They do so on our utility bills, our Internet and cable bills, our online shopping and payment habits, and on sales data from eBay Inc. (Nasdaq: EBAY) and other transaction platforms. That data is sold to third-party aggregators and directly to credit-scoring companies. Data is then modeled and run through proprietary algorithms to generate scores that are more “predictive” than their simple payment-history predecessors.
To keep up with the competition, FICO has had to build and test new models that they hope to make available by the end of this year.
Indeed, Dave Shellenberger, FICO’s senior director of scoring and predictive analytics, told American Bankerthat “using the new data [we] found that more than a third of previously unscorable consumers got above 620 on the new score, representing an acceptable level of credit risk.”
It’s all about modeling – to create “useful” credit-score insights. Said Shellenberger: “Because we’re an analytic company, it’s critical that the data is predictive of future payments.”
Whether you have “impaired” credit – or no credit history at all – understand the New Landscape in credit. Know that your day-to-day bill-paying habits – in fact, all your online purchase and sales transactions – are being gathered up and modeled to determine if you’re a candidate for a loan. And this is being pulled off by any number of the new lending platforms – as well as a lot of the traditional lenders.
Know this and you’re ahead of the game, because you may need to borrow from these folks at some point.
In the Land of the New Disruptors, knowledge is power – as well as an avenue to profit.
P.S. I encourage you all to “like” and “follow” me on Facebook and Twitter. Once you’re there, we’ll work together to uncover Wall Street’s latest debaucheries – and then we’ll bank some sky-high profits.
[Editor’s Note: Shah likes to hear from you. Let us know what you think about the financial Disruptors he’s been sharing with you. Just post a reply in the comment box below.]
Several analysts have recently downgraded Apple Inc. (Nasdaq: AAPL) from “Buy” to “Hold.”Shah, on the other hand, told Fox Business watchers today that now is not the time to downplay Apple’s stock. Between smartphone sales and the just launched AppleWatch, Shah explains exactly why now is the time to buy the iDevice King and stick with it.
While chatting with host Charles Payne, Shah also took a thorough look one of the biggest energy deals in history – the acquisition of BG Group PLC (LON: BG) by Royal Dutch Shell PLC (NYSE ADR: RDS.A). What’s that mean for Shell – and for the energy market as a whole? Take a look to see what Shah thinks.