Apr

3

PhilMost of us are aware of the benefits of portfolio diversification. The simple fact is that it pays to have diversified positions in different industries, countries and even diverse markets. The key to it all is to look at the correlation between the various components of the portfolio.

However there is another kind of risk that many investors are exposed to. It can be fairly assumed that the vast majority of investors are exposed to this single risk in all of their positions. Simply put it is the risk of default if your broker goes under.

There are two ways to defend against this risk. One is to assess the broker's financial position personally. In particular look at how leveraged the broker is. As a rough check one can simply look at the stock chart of the broker if they are publicly traded. If the stock has been tanking faster than the industry it is a clear red flag.

Secondly the investor can identify multiple brokers who appear sound. But even then it makes sense to diversify using multiple accounts with two or more brokers. Remember if a broker shuts down losing half your money is a whole lot better than losing it all. You can still come back.

None of this discussion is meant to assert that the SIPC, FDIC and the many other protective agencies cannot perform on their guarantees for investor safety. Probably they can. But in the eventuality that a decent sized firm goes down, the process to sort the mess will undoubtedly takes months or years. After all it is the government at work. At best you might get all your money back but a very long time from now. Certainly you will miss any buying opportunity which develops from this crisis.

George Parkanyi remarks:

That’s why I pay a little extra commission to deal with a Canadian big five bank’s discount brokerage and not, say, E-Trade (at least not in this environment).

Another point to add is that certain types of accounts are segregated. Registered accounts for example are held in trust, so if your broker goes under, the assets in those accounts are yours. They can’t be touched. It’s margin, short, and option accounts where you have the risk — because the assets are commingled with the firm’s. I believed cash accounts are also segregated.

But if your boutique broker does go bust, it may take a while to sort out the mess and be able to access your segregated accounts, so it’s still a good idea to either steer clear or diversify brokers, as Dr. McDonnell recommends.

J.T. Holley writes:

With FDIC the thing no one realizes is that you are only getting your principle back!  They don't care that you bought a 5 yr CD in 2005 that was yielding 5.5%!  Now get to the back of the line and wait for your $100k!

I had a wonderful lady who happened to be my client back in '01-'03 who passed at the age of 98.  She was risky as heck w/ her "discretionary" money, but her fixed income side of the portfolio was rock-solid.  I once was assisting her with her 1099s for the tax season and noticed that she had 15 $100k CDs at 15 different banks in the area.  I asked her why.  She said that was the limit at each and she didn't want to go through "it again". I asked her to explain and she said she had her money taken in the Great Depression before FDIC at the age of 22. According to her, the only way to properly have your money diversified is as Dr. McDonnell explained! 


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11 Comments so far

  1. Joe Davis on April 3, 2008 9:49 pm

    Unless I'm hallucinating, you are mistaken about the FDIC and what's insured. It includes accumulated interest. Bad enough they only have about 1/1000 of a cent per dollar on deposit to back up the insurance, no need to make it worse.

    Just to clarify, you are insured to 100k (actually quite a bit more if you have titled the account properly).

    So you would have to have deposited less than that initially and kept the principal + accumulated interest under that or whatever limit applies.

  2. Anatoly Veltman on April 3, 2008 9:57 pm

    George, you caught me by surprise: you seemed somewhat professional. I happen to have an account with the firm you're recommending, who is squarely a retail-level firm. The only reason I do: they're giving me a $1,000 cash gift to open with them (this bonus offer is about to expire; and of course, you were not aware of such a gift). In my worst dreams, will I ever trade thru them at 9.99; nor will I keep money with them one day beyond the bonus condition…

  3. Lon Evans on April 4, 2008 3:13 am

    Wow!

    Anatoly, I’ve been told I’ve been harsh. And not that I disagree with your estimation. I’m too ignorant of the particulars to attempt such, but, well, its refreshing to hear a challenging voice among those of the sycophantic “second handers.”

    Long live John Galt.

    lon

  4. reid wientge on April 4, 2008 11:56 am

    It is not just the option accounts. Firms hypothecate shares held in non-option accounts - that is borrow against them to fuel firms options trading. The boutique firm I worked for custodied assets at M&I and State Streeet in accounts that could not be borrowed against and were held separately from the Custodians assets. Suitable for long term holdings but cumbersome for traders.

  5. Anatoly Veltman on April 4, 2008 2:59 pm

    It’s mildly disappointing that no one posts current analysis. Of note is that broad market’s technical condition has improved. This implies that bullish posters are somewhat trend-followers, since SP is trading some 130 handles above 3/17 low.

    It’s also of note: everything is moving up last few days. Not often do you get stocks, bonds and commodities in unison.

  6. George Parkanyi on April 4, 2008 6:03 pm

    Well, Anatoly, the ugly truth comes out - and you called me on it. I’m actually unprofessional. AND I hold retirement accounts and pay retail. There goes the neighbourhood. (It gets worse - I was a stockbroker once - Bache - 1979-82.)

    Was I recommending E-trade? I’m pretty sure I was saying I was AVOIDING them. Don’t tell me I’m senile now as well as unprofessional … boy do I have a lot of work to do. :)

    Cheers,
    George

    PS - Does it count if I was trading commodities for 4 years earlier this decade? At the time I wasn’t doing any other meaningful work so could I have accidentally been a professional without knowing it? :)

  7. Forrest Greene on April 4, 2008 6:45 pm

    According to the FDIC, interest is covered through the date the bank is closed.

  8. George Parkanyi on April 4, 2008 11:12 pm

    Anatoly, on your second comment. The market to me is acting a lot like a bull market does when it’s climbing a wall of worry. There’s still all this bad news, but stocks go up a bit, then they pull back, but not quite as much. (What surprised me was everybody getting all excited about UBS and other financials massively diluting their equity to “raise capital”. That’s their plan?)

    As for current analysis, since MY strategy is basically allocation on steroids, what I really look for is a strong combination of high volatility and non-correlation. I’ve found four long/short pairs of 2x commodity ETFs that give me exposure to each of natural gas, crude oil, gold, and the DJIA AIG grains sub-index (beans, wheat, and corn). All these markets are up a lot, with big money tied up in them, and with the first warning shot across the bow (recent declines). 3 are further subject to weather, a couple to demand pressures, and all are subject to human folly. This is a perfect cocktail for some nice volatility - with instruments available now that don’t have “best-before” dates and that never go out of the money. To me, this is symphonic - I’m happy as a clam and now don’t really care WHICH way the market goes, just as long as it goes.

    My current long/short bias is 60% net long on equities (as a consequence of having recently added 4 short commodity ETFs and 2 equity index short ETFs in my portfolio mixed in with a bunch of other long stocks and ETFs - I’m trading off some near-term upside potential (and risk) for non-correlation and beta).

    Cheers,
    George

  9. Max on April 5, 2008 1:19 am

    I`M from Russian.There is artikle very like to me.It is a nessesary.

  10. Anatoly Veltman on April 5, 2008 9:59 pm

    George, your post reminded me of Nassim Taleb contributing to morning call at a major house, early in his days. Asked “you’re saying by all appearance, SP is poised to rise a little through the week. But you are holding puts?”, he replied: “that’s exactly WHY!”

    Max, al man kan e-male me iff wanted $1,000 prasent to open a/c: zeir ofer kaput soon

  11. George Parkanyi on April 6, 2008 9:47 am

    Anatoly,

    Let me put it another way. In the area of predicting short-term day-to-day moves, I am utterly useless, other than if I did try to make such predictions you could probably fade me with some success.

    I’m more focused on the environment that I am in, and how to position different securities for multiple possibilities, some of which may not play out for quite some time.

    I am not a speculator in the traditional sense - if there is such a thing. I’m not looking for set-ups to make the next specific trade successful. I’m simply trading on one fixed setup and optimizing my overall portfolio mix to have that one simple decision maximize a particular compounding effect and hence my return - in aggregate over many trades - over time.

    Hope that helps - or unhelps,
    Cheers,
    George

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