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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