The appeal and respectability of peer-to-peer lending continues to rise, creating a win-win situation for both the borrower and the lender. Prosper.com , a leading P2P lending website, has already surpassed $135 million in loans, and according to the Online Banking Report, the volume of peer-to-peer loans may hit $9 billion by 2017.

Certainly, peer-to-peer lending has both its advantages, as well as its risks. Like any type of investment, diversification is the key to mitigating the risk of loss in your portfolio. When you treat your peer-to-peer investments like you would your stock portfolio, then in the long-run, you can ensure that your gains will significantly outpace any of the losses on defaults. Here are several tips for creating the best blueprint of diversification for your peer-to-peer lending investments.

Rainbow of risk-to-reward ratios

Like the equity and bond markets, peer-to-peer offers you the insight of ratings, which are in the form of credit scores. With borrowers having AA to HR (high risk) credit, the risk-to-reward ratio is clearly in play in peer-to-peer lending. The higher the risk, the higher the interest rate you can bid.

Think about your goals for peer-to-peer investing, as well as your personal style. Are you looking for aggressive growth, earning 20% per year in interest? On the other hand, do you prefer stable, steady passive income, with minimal risks?

Keeping your goals in mind, intelligent asset allocation in your peer-to-peer portfolio can provide you with great diversification. You want to enjoy the benefits of large returns, while minimizing your risk. For example, if you are a moderately aggressive investor, then you can allocate 60% of your loans to A and AA rated borrowers, 20% to B grade, 10% to C grade, 6% to D grade, 3% to E grade, and 1% to HR grade borrowers. In this sense, even if your “riskier” investments default, the bulk of your capital will still be retained through your lending to the top-tiered borrowers. However, if the risk-to-reward ratio pays off, you will be met with handsome returns.

From California to New York: diversifying geographically

Domestic investors are looking to place their stock portfolio funds in more economically vibrant areas, such as the EU and Japan. Although Prosper’s borrowers are located in the United States, you can still use geographical diversification to your benefit.

Indeed, each borrower should still be evaluated on a case-by-case basis, but you should diversify your portfolio across the country. For example, lending home improvement loans to borrowers in Florida and Nevada, which have dramatic foreclosure rates, has greater risks than residents who reside in more stable real estate markets. Or, providing business loans in borrowers who reside in the more economically affluent states, such as California and New York, can stabilize the riskier borrowers from states who are suffering from recessionary job cuts, like Michigan. Although global diversification is not possible, you can still control the risks in your peer-to-peer portfolio through geographical diversification.

Investing across the industries

With peer-to-peer lending sites, you have the option of choosing different loan categories: debt consolidation loans, home improvement loans, business loans, personal loans, student loans, car loans, or other types of loans. With this in mind, diversifying your investments across the different categories, as well as industries, can help you minimize your risk.

Distribute your peer-to-peer portfolio throughout the different categories, paying careful attention to the various weights. With the current housing crisis, do you want to be heavily weighted in home improvement loans? From a financial standpoint, that may not be the best type of loan to provide. However, it can provide solid returns, especially if the borrowers are backed by home equity. Applying an even mix of diversification among the different categories can help you maximize the returns, while minimizing your risk factors.

With business loans, choose an even spread of business models and industries. Being too heavily weighted in one particular industry increases the risk in your portfolio. As you would split your equities portfolio between the tech, healthcare, consumer goods, and finance industries, do so with your peer-to-peer lending portfolio as well. In addition, keep in mind the impact economic weakness or a potential recession will have on the business loan. While a grocery distribution company may fare well, lending to a high-end gourmet dog bakery may result in a default when consumers tighten their belts.

Diversification reigns king in maximizing your returns, while minimizing your risk. In fact, diversification is one of the few proven methods that systematically reduce risk. Apply the same principals you use in your equities investing to your peer-to-peer lending portfolio, and in the long run, your returns will be impressive.

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