The biggest concern for most retail investors is knowing when the next financial crisis will come as they worry that their investments may go down in value significantly.
Questions are always raised about the 7 year cycle and how ‘we must be close to another financial crisis’.
The truth is that financial crises are not often predictable and the best advice during those periods is typically to do nothing at all. If anything, investors may be better placed to look at crisis situations as an opportunity to buy.
Aside from the fear of an impending financial crisis, there’s a more pressing issue that less experienced investors overlook. This issue is what happens when your broker goes bust.
It’s important to highlight that a brokerage firm is a business. If they get into financial difficulties, this could be a major problem for your investments.
Risk that is associated with the financial health of a broker is appropriately called provider risk.
If your broker goes bust, you may lose track of your investments completely. If you pick a less noteworthy broker, you may lose all of your money – which is clearly something to be worried about.
When picking a broker, make sure that they are registered and authorised by the financial conduct authority (the FCA). That way your investments will be protected under the Financial Services Compensation Scheme.
If your investments are protected and your broker goes bust, you’ll be eligible to receive up to £85,000 in compensation.
Clearly, some investors will have more than £85,000 in their broker account. For those people, they may lose substantial amounts of money if their broker goes bust.
Even if you think that you’ll never have that sort of money in your account, over time your capital can compound to significantly large amounts.
For instance, if you invested £12,000 into the S&P500 (10% average return) with £200 added on a monthly basis, after 15 years you’d theorectically end up with around £126,380.93.
£41,380.93 would therefore be left unprotected under the current provisions of the Financial Services Compensation Scheme.
Of course, the hope is that your broker never faces financial difficulties. One way to assess the financial health of your broker is to undertake fundamental analysis on a regular basis.
It may not be possible with every broker but some are listed on the stock market. For example, AJ Bell are listed on the FTSE 250 index and Hargreaves Lansdown are part of the FTSE100 index.
Brokers to be wary of are international brokers. If they are not situated in the UK and are not registered with the FCA, your investments may not be protected at all.
You want to be wary of investment apps that allow for casual investment. You equally want to be cautious with apps that allow you to buy a certain percentage of a stock, like 5% of one Apple stock. Anything unusual like that requires diligent investigate before proceed in with.
In short, you need to do your research and make sure that your working with a broker that allows for your investments to be protected.
Now that you’ve focused upon finding a reputable broker to deal with, you still need to be aware that your investments are only covered up to the value of £85,000.
This is problematic if you intend on build wealth above £85,000 or if you start off with an investment pot that is larger than £85,000.
Much like with investment risk, the best think to do with provider risk is to diversify. If you diversify providers, you will reduce your exposure to provider risk.
You might be wondering how you can diversify provider risk. The answer is simple, you just need to open multiple broker accounts with multiple providers.
Obviously this has the negative effect of adding to your cost of investing. The trade-off though is a no-brainer.
Many brokers in the UK charge around 0.25% per year for their custody service, with a maximum annual fee of £30 in a lot of cases.
So, if you open 5 broker accounts, it would cost you around £150 a year. If you invested £10,000 into each, it would represent 0.3% of the total invested amount of £50,000.
This is obviously not so bad if the return on investment is the market return or higher (10%+).
It’s certainly a worthy trade off for full protection under the terms of the Financial Services Compensation Scheme.
The alternative would be to invest £50,000 into 1 broker account. Assuming that the capital return the market rate (10% on average), after just 6 years, some of the capital gains would be unprotected.
You can see how having 5 broker accounts is better in terms of protecting your investments. With 5 broker accounts, you’d have to multiple each £10,000 sum by 8.5 to exceed the provisions, which would take several decades in most cases.
When it comes to investing in other countries, the most common option is to invest in the United States.
Companies like Amazon, Apple & Microsoft have grabbed the attentions of global investors for obvious reasons.
As long as you maintain a valid W-8BEN form, your investments will be protected under the laws of the United States.
Should something go wrong with an investment in the United States, your broker will deal with the process, much like how they do with dividends.
This becomes less certain as you invest in other countries, particularly those that are developing.
Popular countries that attract attention include China, India and Russia. These countries are a part of a large group of countries that are known as emerging markets.
In emerging markets, the stock market system is less developed and is therefore greatly exposed to risks associated with a lack of regulation, unstable politician environments, a lack of liquidity and poor corporate governance.
Brokers will often charge more for trades into emerging markets as it is often the case that more work is required when dealing with counterparts in those markets.
When investing in emerging markets, your money may have very little protection. It could be the case that your investment ends up being stuck in a country, being stolen or lost through inefficient trading systems.
To avoid these issues, the safest thing to do is to invest in countries that have stable, developed markets.
Investments in emerging markets are often hyped up by the media but it’s important to shut out the noise. Investment in China has particularly been a hot topic as an example.
Before making any investments, it’s important to know what the risks are, how well your money will be looked after and whether you will comfortably see the money again or not.
Emerging markets are considered very high risk, not only in terms of investment returns, but also in terms of the custodian risk.
If you open a UK-based brokerage account and invest in foreign companies, you will be covered by the Financial Services Compensation scheme on those investments.
In some cases, you can even get all of your stocks back as they are usually held by a third party (usually an investment bank) in that foreign country.
For example, if I buy Apple stock with AJ Bell, the stock may be held with an investment bank like JP Morgan within the United States, on your behalf.
AJ Bell are ultimately responsible for that investment but are using JP Morgan as a partner to have custody over the stock.
This is a very common structure as stocks cannot leave the United States, unless a company lists on multiple stock markets.
Anyway, as AJ Bell are responsible for that investment, you are covered under the Financial Services Compensation Scheme.
This wouldn’t be the case if you were using a broker that is located in another country, even if they have been issued with a passport to operate in the UK.
Wherever your broker is located, the local laws will be applied to your investments.
For example, if you were using an American brokerage firm, you’d be protected up to the value of $500,000 in stocks, $250,000 in cash. In the USA, this is called SIPC coverage, a kind of insurance that was developed by the government.
While this is a good amount of protection, it could be the case that there are barriers to retrieving this money from the US government. This is obvious when you consider that you probably do not live in the United States and are not guaranteed a visa as a result.
The point is that you may face difficulties in receiving your compensation if your broker is operating in a different country.
If this is the case for the United States, you can just imagine that it would be a lot more difficult in a country like China or Russia.
The best thing to do is to use a broker that operates in your own country, that way you can more easily hold the company (or the government) to account if things go wrong.
The seriousness of this point is important when many retail investors have been found to simply download apps and start investing large sums of money, without evening thinking for a second about the company that they are investing with.
There are definite consequences that can happen should things go wrong. It’s better to do things properly in order to avoid losing money.