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(This post is for investors and lenders. If you need a loan or debt consolidation, check out my LendingClub vs. Prosper comparison for borrowers.)

As part of my new Beat-the-Market Experiment, I have dedicated $5,000 to Prosper. As a quick recap, Prosper.com securitizes person-to-person loans so that you can lend money to other people in $25 increments and earn interest. The idea is to replace banks and credit cards as the middlemen. Since their mid-2009 re-launch after SEC registration, there have been a full cycle of 3-year Prosper “2.0” loans fully maturing with an average net return of over 8% annualized. However, this is still unsecured lending which means no car or home as collateral, and thus there is a risk of loss (which can be mitigated by diversifying in multiple loans).

Prosper looks at the credit history of prospective borrowers and charges them an interest rate based on a Prosper Rating of AA, A, B, C, D, E, or HR (high risk). (The ratings are relative; the minimum credit score is 640.) Now, if Prosper’s grading system was perfect, life would be simple. The interest rate charged would be high enough to cover any defaults plus a little extra for the added heartburn. Ideally, after defaults and fees are accounted for, perhaps AA loans would earn 6%, C loans would earn 8%, and E loans would earn 10%.

However, things aren’t quite that neat. Prosper publicly shares all its loan information, and smart folks have made tools to analyze that data. Currently, the best place to go is Prosper Stats. If you take all the loans, we see that AA loans have a net return (after estimating losses from late loans and actual losses from defaults) of ~6%, C loans had a net return of ~11%, but E loans only returned ~9%. Hmm. Look further and you’ll see other small inconsistencies. For example, loans to people with 2 or less open credit lines actually have a measly 3% net return, while loans to folks with 18+ open credit lines open have net annualized returns of over 11%?!

As a result, many investors avoid investing in Prosper loans blindly and instead use specific search filters. Indeed, Prosper makes it easy with their “Automated Quick Invest” service which automatically invests in loans that satisfy your custom search rules. There’s no need to spend time every day looking for loans. So, what are some possible criteria?

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Update: Check out the monthly updates on this experiment.

Do you think you’re a below-average driver? Of course not. Everyone thinks they’re above-average. This is why I’m a big proponent of the “Core and Explore” or “Play” portfolio. You should set aside a small percentage of your portfolio and try your best to beat a passive benchmark. If you track things carefully, chances are that after a few years you’ll discover you really aren’t so good and hopefully end up settling into the slight-but-guaranteed outperformance of low-cost, passive investing. Or, you’ll find you’re meant to be a rich and successful hedge fund manager. Win-win!

I’ve been running a little side portfolio for years, but I haven’t been following my own advice about tracking my relative performance. I think it’s time. I’m taking $30,000 and using it for my “Beat the Market” experiment. This is less than 5% of my actual portfolio, which is still overwhelmingly in low-cost index funds rebalanced to a target asset allocation. I’ll track the balances monthly with actual screenshots starting today, November 1st, 2012. Here’s how I’m breaking it down.

$10,000 “Good Boy” Passive ETF Benchmark Portfolio

My real portfolio is held primarily at Vanguard and Fidelity but also includes non-index funds due to limited 401k choices. To create a separate benchmark, I opened a new account at TD Ameritrade as they offer 100 of the most popular ETFs commission-free, including the Vanguard and iShares ETFs that I use. My benchmark portfolio will be based on my usual target asset allocation, except fully-invested in 100% stocks (details coming). As the portfolio will consist of commission-free ETFs and there are no maintenance or service fees, the overall cost drag should be very, very low.

I will not make any deposits or withdrawals to this account, and will report the total balance on a monthly basis. I suppose I could also track after-tax efficiency, but that sounds like too much work and most people invest predominantly in 401k’s and IRAs anyway.

(I know, it has $15,000 in it right now, I already submitted a withdrawal request for $5,000.)

$10,000 “Bad Boy” Beat-the-Benchmark Portfolio

In this account, I’ll be able to buy whatever: individuals stocks, ETFs, options, and even short stocks as needed in my attempts to crush the Benchmark portfolio above. I liquidated the holdings in my existing TradeKing account and left $10,000 in there. This will serve as a low-cost, no-fee brokerage account with $4.95 trades and 65 cent options contracts. (TD Ameritrade standard pricing is $9.99 a trade.)

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I’ve decided to invest $10,000 in Prosper and Lending Club to compare their performance as an investment. Putting $5,000 in each will allow me to invest in 200 loans at $25 a piece, so that each loan will only be 0.5% of each respective portfolio. The money has already been deposited:

Prosper Screenshot:

Lending Club Screenshot:

Prosper advertises returns of seasoned returns of 10.08%. Lending Club advertises rates of 5.81% to 9.43% depending on credit grade, but always with prime borrowers. I want to compare both absolute performance and the investing experience (ease of use, customer service, liquidity, etc.). However, I’m not sure exactly how I should run the experiment…

Background
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I kinda missed the boat last Thursday 2/17 because peer-to-peer lending site Prosper.com had a promotion going on for borrowers that stated that they would make a entire month’s loan payment for you. A quote from their e-mail:

It’s our fifth birthday, and to celebrate we have a special gift just for you! If you apply for a loan and submit a listing on our site today, February 17th, we will make your second loan payment (up to $300)*!

Astute borrowers realized that they could simply take out a loan and pay it back after 2-3 months since there was no pre-payment penalty. After all loan initiation and other fees, the borrower could still net a little over a hundred bucks. Not bad for “borrowing” money!

However, this also meant that somebody had to fund their loans. I’m sure some potential investors found it weird that Prosper suddenly had a lot of AA-rated loans from folks with very good credit and peculiar descriptions like “I really don’t need this money for anything, and intend to pay this loan off in 3 months.” 🙂 The requested loan amounts will also be very close to $3,500, the ideal amount for profit maximization.

To top it off, I just got this e-mail from Prosper regarding getting 1% cash back on any bids placed on Monday, February 21, 2011. Here’s the e-mail text. No special link or promo code was given, so I can only assume it is open to all.

This offer is as straight-forward as they come: invest in any listing on the site today, and you’ll earn 1.0% cash back*! With a cash back offer and returns averaging 10.1%**, why wait?

* The promotional period begins at 12:01 AM PT and ends at 11:59 PM PT on Monday, February 21, 2011. 1.0% cash back will be paid on all bids placed during the promotional period that ultimately become funded loans. Cash bonus will be deposited to your Prosper account by March 31, 2011.

Update: Promotion extended to end of 2/23:

* The promotional period began at 12:01 AM PT on Monday, February 21, and will end at 11:59 PM PT on Wednesday, February 23, 2011. 1.00% cash back will be paid on all bids placed during the promotional period that ultimately become funded loans. Cash bonus will be deposited to your Prosper account by March 31, 2011.

Now, if you could technically find and fund several of these high-quality borrowers who have an incentive to pay off their loan in 3 months, you could have an investment that would return around 1% in interest + 1% cash back over a period of just around 3 months. That’s a lot better than a savings account.

I know that some of you readers got in on this. If you’re still looking to get funded, share your loan listing below using your usual commenter e-mail. This is not risk-free as you are still lending money to strangers, but if you’re an AA borrower on Prosper who initiated a loan listing on 1/17th or shows as early on 1/18th for ~$3,500, then I am more willing to take the risk. I am relatively comfortable with P2P lending with certain criteria, and already have over a few thousand dollars in highly-rated loans on LendingClub.