We have all heard the expression, "The higher the risk, the higher the reward".

How do you view this when it comes to investing in LC Notes?

Let us first consider some possible parameters:When investing in stocks investors often consider, for example, the ROI (or IRR), Risk/Reward ratio and Sharpe ratio:

**ROI:** Is the total return on investment

**IRR:** Is the internal rate of return and takes into consideration when money was invested. This allows comparison with other investments, such as a CDs and Bonds.

**Risk/Reward ratio:** In case of Notes, the risk is that the borrower defaults on the loan or pays less than expected (e.g. on a payment plan). The reward is basically the interest rate minus fees (annually 0.46% for 60 months loans and 0.70 for 36 months loans) .

http://www.investopedia.com/terms/r/riskrewardratio.asp#axzz2Ie4jA3Yi**Sharpe Ratio: ** The Sharpe ratio tells us whether a portfolio's returns are due to smart investment decisions or a result of excess risk. The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance has been. It is defined as SR= (Rp-Rf)/Sp, where Rp=expected portfolio return, Rf= risk free return (e.g. Bank account), and Sp= Portfolio standard deviation= Portfolio Standard Error*sqrt(N), where N is the number of notes in the portfolio.

http://www.investopedia.com/articles/07/sharpe_ratio.asp#axzz2Ieg8kkYjNext, let us consider these parameters when investing in different loan grades. I used Interest Radar for the statistics below;

**Loan # Interest Loss % Std Error IRR (α=.05) ROI Av IRR Risk/Reward Sharpe Ratio Grade**

20443 7.50% 1.80% 0.20% 4.3% - 5.0% 5.70% 4.65% 26.01% 1894 A

29635 11.70% 3.10% 0.20% 6.7% - 7.6% 8.60% 7.15% 27.88% 4433 B

19199 14.60% 5.00% 0.40% 7.3% - 8.7% 9.60% 8.00% 35.66% 2078 C

12251 17.30% 6.40% 0.50% 8.2% - 10.2% 10.90% 9.20% 38.28% 1594 D

5896 19.50% 8.10% 0.80% 8.0% - 11.3% 11.40% 9.65% 42.81% 734 E

2311 21.60% 9.50% 1.60% 7.0% - 13.2% 12.10% 10.10% 45.20% 243 F

572 22.80% 13.00% 3.30% 1.8% - 14.6% 9.80% 8.20% 58.51% 45 G

Where I calculated: ROI=Interest-Loss; Av IRR=(Lower IRR+Upper IRR)/2; Risk/Reward=Loss/(Interest-LC Fee*); Sharpe Ratio=(AV IRR-2%**)x sqrt(Loan#)/Std Error

*) LC Fee = 0.58%; **) Bank Interest =2% (This is my minimum return)

We see that ROI and Av IRR gives the same relative order of the Loan Grades, with F loans giving the highest returns and A loans giving the lowest return. As we would have expected from the statement "The higher the risk, the higher the reward", the risk/reward ratio is just the opposite, with A loans having the lowest risk/reward while F (and G) loans having the highest risk/reward.

*Note that G loans have the highest Risk/Reward, but only has a mediocre return. Thus, the higher the risk/reward of G loans does not mean higher reward (IRR). *.

Next consider the Sharpe Ratio; It is highest for B and second highest for C loans, which both have a higher ratio than the A loans which had the lowest Risk/Reward ratio. This is because there are many more B loans in the testing portfolio and the volatility (as given by the standard deviation) is therefore lowest for the B group. In other words, with a B Notes portfolio we are "more certain" that we will get an IRR around 7.15% than an IRR of 10.10% with a portfolio of E notes.

Next I will consider a more sophisticated strategy than simple portfolios based on Loan Grade. Again, I have used Interest Radar and used variations of their proprietary IR01/IR04 score strategy named

**D-G Top Score** (The First strategy is the original strategy):

**Loan # Interest Loss % Std Error IRR (α=.05) ROI Av IRR Risk/Reward Sharpe Ratio IR01 IR04**

1113 19.50% 3.10% 1.80% 11.0% - 18.1% 16.40% 14.55% 16.38% 233 400+ L

2172 19.10% 3.00% 1.20% 11.9% - 16.6% 16.10% 14.25% 16.20% 476 400+ L, M

3042 19.20% 2.80% 1.00% 12.7% - 16.5% 16.40% 14.60% 15.04% 695 400+ L, M, U

3342 19.20% 2.80% 0.90% 12.6% - 16.3% 16.40% 14.45% 15.04% 800 400+ L, M, U, H

2562 19.40% 3.20% 1.00% 12.4% - 16.5% 16.20% 14.45% 17.00% 630 390-399 & 400+ L

7107 18.80% 4.50% 0.70% 11.1% - 13.8% 14.30% 12.45% 24.70% 1259 390-399 & 400+ L, M

11579 18.60% 4.90% 0.50% 10.9% - 13.0% 13.70% 11.95% 27.19% 2141 390-399 & 400+ L, M, U

14990 18.40% 5.40% 0.50% 10.3% - 12.1% 13.00% 11.20% 30.30% 2253 390-399 & 400+ L, M, U, H

In this case the highest return (IRR) is from the the 3rd strategy down, which gives IRR=14.60% (in green). Interestingly, this strategy also has the lowest risk/reward ratio of 15.04% (Red)!

*Thus, when we apply a more sophisticated strategy, the higher return does not necessarily mean an increased risk/reward ratio!* The only "disadvantage" of this strategy is that the Sharpe Ratio =695 is not the highest (highest is 2253 in blue for the last strategy, with IRR=11.20% and with twice the risk/reward ratio), but it is still in the top 50% of the strategies. Furthermore, a Sharpe Ratio of more than 3 is usually considered Excellent (

http://www.investopedia.com/articles/07/sharpe_ratio.asp#axzz2Ieg8kkYj).

Another thing to consider when choosing a strategy is the availability of Notes meeting the criteria and other parameters that I may not have touched on.

**How do you determine which strategy is the "best"?**