How investors within alternative finance can make better decisions

By Clare Flynn Levy, CEO and founder of Essentia Analytics

a woman with long hair

To say that alternative finance is “on the rise” is an understatement. In fact, we may well reach the point where the ‘alternative’ part becomes something of a misnomer: to the benefit of thousands of individuals and small businesses, the sector has been growing rapidly - it is projected that £12.3bn will be loaned or invested in 2020.

For investors specifically, initiatives like crowdfunding and peer-to-peer lending are appealing for several reasons. By cutting out the middle man (usually the banks), these platforms are able to offer favourable rates, while still protecting their investors by spreading the risks over multiple recipients.

At the same time, the opportunity to support small businesses or individuals appeals to a certain type of investor.  Many of the recipients of these investments or loans will have been denied traditional bank funding – but just because a bank isn’t willing to lend capital doesn’t mean an idea is unprofitable. This means that alternative finance provides many opportunities for investors that might not have otherwise existed.

But for all that alternative finance presents a genuine divergence from bank hegemony, this type of investment is still subject to many of the same pitfalls. The most obvious reason for this, to my mind, is that there are people involved, and people have flaws when it comes to making investment decisions. And worse still is that they are often unaware of these flaws!

Same as it ever was? 

There are, of course, some key differences. For example, a more traditional investor’s sole purpose is normally to make money. They will often make decisions based on the belief that they can “beat the market,” and focus on price patterns or on other data that attempts to predict what “the herd” is going to do next.

Alternative finance investors answer to different masters. Many are motivated by factors other than money. A CrowdCube survey of its user base indicated that contributors, knowing that small businesses tend to be ‘high-risk’ investments, will often take it for granted that they will fail: they see the money they invest is that which they can ‘afford to lose’, and they will spread it across several businesses. A separate report suggested that many were driven by ‘activism’ and a desire to ‘support British startups’. Admirable goals, to be sure, but are they really prepared to see those investments go to zero? Only time will tell.

How alternative finance investors can make money

What the traditional investor and the alternative finance investor have in common is this: they usually fail to identify the financial impact of flaws within their conscious investment processes, and moreover, the impact of their inherent unconscious biases. Regardless of how intentionally an investor is letting passion guide them, if profit is the end goal, an investment process that includes some objective checks and balances is key. 

It might be as simple as creating a basic checklist of research you will do on a given investment before you put money into it, and including at least one step designed to factor in an opposing view. But if you do this in a structured way, using technology, you can start collecting data on your own investment behavior. Then, if you leverage technology to analyse that data for insights into where your strengths and weaknesses lie, you can create a 360-degree feedback loop (like those used by professional athletes), which enables you to continuously improve your returns.

Despite the notion that alternative finance investors are investing money they can ‘afford to lose’, they are as prone to ‘loss aversion’ as anyone else. We humans don’t like taking losses – it’s hardwired into our brains.  In liquid markets, that causes us to hold on to losing positions for too long. In the world of alternative finance, liquidity often doesn’t exist, which in some way avoids the problem – taking a loss isn’t an option. But it also means that investors should be all the more careful about getting their selection processes right, lest they watch multiple investments go to zero.

Intelligent alternative finance

In terms of personal and professional risk and reward, alternative finance often seems to have smaller stakes than traditional bank-driven investment. But you don’t need to be a professional to use a structured investment process, and you don’t need to be a data scientist to track and analyse your own behavior. It is as simple as using technology to record the reasons behind your investment decisions and the contexts in which you have made them, then doing the math to identify behavioural patterns. If alternative finance investors aim to optimise their own investment processes, they will no doubt see the benefit in increased returns.

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