Kevin over at RateLadder had a really interesting post this weekend on the discrepancy between what his Quicken records indicate for rate of return on his Prosper loans, and what Prosper reports:

Quicken enters the money into the account the moment the money leaves my account and it only acknowledges interest after it has been paid. Prosper only counts money in loans and acknowledges interest the moment it is accrued. Both acknowledge default sale amounts the moment they happen. Neither approach attempt to project a future loan’s value.

What does this mean? Well it means that with Quicken you can get the ROI for the moment the money enters the account with interest only for actual payments received. With Prosper you get the ROI for the loans with all accrued interest. Since you can only deduct defaulted principal (cash basis) I feel that Quicken’s approach is correct.

You can see the discrepency in the chart he provided below:

I haven’t run the numbers on my own account, but I believe that the cause of this discrepency is due to the difference between tracking the actual return on the cash moved to Prosper vs. the actual loans themselves. When you move money to Prosper, it wastes time. It takes some time for money to appear in the new account, and it takes time to bid and win loans to invest the money. As a result, your money does not spend 100% of its time in loans, and thus your actual return is lower than the Prosper reported return on your loans.

This is a really important financial concept to grasp, and it extends to other instruments besides Prosper.

First, when you invest in bonds, loans, or other fixed-income investments, re-investment risk is real. Re-investment risk is the risk that when you receive interest payments, you may not be able to re-invest them at the same (or better) rate of return. Prosper is an example of this, since the minimum investment is $50.00, you have to accrue payments until you have another $50.00 to lend. That time spent uninvested is time spent earning a big fat 0%.

Second, when investment vehicles report returns, they only report returns for specific time periods. Your actual returns, however, reflect your actual dates for moving and investing money. Mutual funds are notorious for this, as they tend to report annual results for very specific 1-year, 5-year, and 10-year dates. Because people rarely have invested all of their money on exactly those dates, their returns can vary significantly.

Imagine a fund that on January 1st earned 20% (big day!), and then earned -2% the rest of the year. Their prospectus would brag about an 18% return last year. If you actually moved your money into the fund on January 2nd, you might be wondering why your account actually lost money that same year.

I hope these two tips are helpful the next time you’re looking at your investments and wondering, “Why don’t my returns match the ones on the website?” Caveat Emptor, my friends.