It’s 6 o’clock, do you know where your advisor, fund manager, clearing agent, or broker are? If you’re answer is “in line for EI”, then you may well be experiencing one of the most frustrating investment risks imaginable, the bankruptcy of a brokerage house. While this risk was considered pretty much unimaginable even as early as 6 years ago, the crash of 2009 (and the ensuing recession) very clearly showed how power-brokers like Bear Sterns can go bankrupt overnight, and leave clients in want of assets.
Worse yet, companies like MF Global might not even be pursuing reasonable best-practices during their final hours, resulting in millions of lost dollars and funds for investors. I’ll take a minute to describe the basics of what goes on when your brokerage house liquidates under the Securities Investor Protection Act, and then go into detail about how it is you can diversify away an amount of this risk to keep yourself out of a bind.
When a brokerage house becomes insolvent, the Securities Investor Protection Corporation begins transferring the holdings of the failed brokerage’s clients to other solvent firms. However, if the SIPC can’t find these funds due to poor practices (such as is the case with MF Global), it becomes very difficult to distribute these assets. The result? Some of these stocks just never find their way back home.
In the event that these assets are lost, the SIPC sends investors a check for the market value of the instruments, which may have materially changed in value over the course of time in which the SIPC was looking for the assets. While the investor is eventually made whole on the market value of their holdings at some point or another, the time-value risk of a brokerage bankruptcy is enough to cripple your savings. Think about an economic climate in which brokerages are failing, you don’t want to be forced to wait before you can sell into the crashing market.
There are a couple of ways to hedge against these sorts of risks. Some insurance companies will offer relatively affordable plans that will protect the value of your fund at the time of insolvency. Other times, we’ve seen that the federal government has been willing to bail-out failing banks to ensure that their insolvency doesn’t have a material impact on the greater economy (**note: don’t ever expect this to happen again.**). Personally, I feel as though diversification is the best way to mitigate this risk. How do we achieve this kind of diversification? We simply split up our assets, and trade them through different investing accounts.
If you’re doing your own personal trading through a discount broker, why not just open multiple accounts and equally balance your portfolio across all the companies (it’s cheap a pretty cheap solution). If you’re trading with an advisor, consider coordinating an agreement with multiple banks to synchronize your portfolios under a single advisor that is considered to be your main point of contact. Realistically, this latter option is only really available to larger clients, but it clearly demonstrates our intentions, and our capabilities.
By spreading our or insuring our holdings, we are protecting ourselves against the risk of extreme market volatility, caused by the collapse of our brokerage firm. However, if the mortgage crisis taught us anything, it’s that our economy is far more interconnected than we could ever imagine, especially when if comes to dealing with investment firms. So if one of our investment companies fails, and all of these companies are intertwined in one way or another, how is it that we can protect ourselves against an absolute economic dooms-day scenario?
