“Not tonight mate – you’re not comin’ in”

7 mins. to read
“Not tonight mate – you’re not comin’ in”
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Master Investor Magazine 42 cover

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Whenever you invest in anything you are assuming two types of risk, and in order to make money effectively you need to understand both of them.

The first type of risk is ‘credit risk’ and the second type is ‘market risk’.

Credit risk refers to the risk that the company which you are investing through will run off with your money. In other words, you could find a fantastic investment opportunity but if you buy it through Del Boy Trotters & Co. you might find that Rodney is the one who becomes a millionaire this time next year, not you.

The second type of risk is investment risk which is pretty self-explanatory – it’s the risk of the investment itself. When you buy shares in BP for example, you are taking on the risk that the price of oil might fall or that the business is fined for a massive oil spill. It is essentially the risk of the share price going down.

Risk is critical to making money because without a deeper understanding and knowledge of the risk that you are assuming, any investment is just pure gambling. That’s because making money on any investment is based upon ‘risk and return’.

Whilst this is such as simple concept in principal, it still seems to prove elusive to many investors who focus on the return almost exclusively. And those that do focus on risk often completely ignore the credit risk part of the equation.

So, let’s focus on credit risk for a moment.

Keeping credit risk at bay

The good news is that unlike market risk, which most investors have little control over (other than sensible hedging and insurance policies), credit risk is very much in our hands. We can choose to be silly and buy investments which are not regulated and therefore are afforded no regulatory protection, or we can choose to be sensible and buy things which are protected. The choice is ours but the sales-techniques from those wishing to sell you unprotected investments packaging them as ‘asset-backed’ and ‘protected’ can be convincing.

There is an organisation which you will have heard probably heard of, it’s called the Financial Services Compensation Scheme (FSCS). Its job is very simple – it’s to protect you from scammers and it works like this.

All companies that are authorised and regulated by the Financial Conduct Authority (FCA), mine included, pay a financial levy money which allows the FSCS to operate. The amount of money that each regulated firm pays is calculated by a number of variables and changes each year, but whatever the figure is – and regardless of whether the authorised firm agrees with the calculation – it has to pay. It’s not up for discussion, less still negotiation. You just have to pay up, put up and shut up (usually in that order).

It’s like being part of an exclusive membership club where the members have to pay an annual subscription. And if you think it’s too expensive, well then cheerio, and you are free to join another club.

Oh, hang on a second, there’s just one problem. That’s right, there is no other club.

A friendly monopoly

When faced with this form of monopoly dictatorship it may seem a pretty rough deal but actually it’s the exact opposite. By paying into this club, it tells investors that if they choose to invest through a firm that might later go bust, they would be completely protected because the club would bail you out.

In fact, an investor will get back 100% of the first £50,000 from any investment that they make if the company that they deal with falls into administration. For cash deposits this figure goes up to £85,000 and so if your bank disappears, as happened to Northern Rock a decade ago, then at least you know that your money won’t disappear with them.

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And so that’s exactly where the financial contributions of authorised firms ultimately end up – to bail out those who disappear. It’s quite unfair really if you think about it. A company that is badly run or doing something dodgy makes millions of pounds and then just disappears with their clients’ money and those who are doing things properly are the ones that have to bail them out.

I remember many years ago there was a company called Pacific Continental which made millions of pounds on something called principal dealing, which was basically shorthand for ripping off clients through buying penny shares at 0.1p and selling at 10 times its face value. Anyway, they got away with it for many years until the company filed for bankruptcy.

Once it became clear that there was serious malpractice and that the clients should be compensated, the FSCS paid back tens of millions to their clients! That’s great news for the clients but not so good for the other authorised firms who as a direct result saw their levies increase in subsequent years.

And that’s why it really isn’t fair. It’s a tax that is placed on the law-abiding and sensible to pay out those who mess up whether intentionally (ripping people off) or just because they are stupid (they don’t know how to run a business).

My loss is your gain

That said, without a system such as this in place which offers 100% investor protection, there would be no confidence in the market place, which would actually be far more damaging.

Since its inception in 2001, the FSCS has helped nearly 5 million people and paid out the best part of £30 billion – that’s staggering and brilliant work in my opinion. It’s brilliant because it is putting money back into the pockets of everyday investors who have been ripped off or lost money through no fault of their own.

Even if I don’t agree with the idea that I should be paying for somebody else’s mistake it’s hard to think of what an alternative system might look like and until somebody far more intelligent than me can find a solution to this conundrum, I have come to terms with the fact that I just have to pay up and put up (oh yes, I nearly forgot, and shut up).

But my loss should be your gain. The fact that I and thousands of other authorised firms like mine have to pay into this pot of money so that you can sleep easy at night should not be underestimated. And on the other side of the coin I am of course an investor myself and so I also benefit from the protection.

Indeed, we are all investors of some description, which is why we mustn’t forget the value of what the FSCS provides us all. It eliminates a huge amount of risk for you and me that would otherwise be present.

That’s why it’s so important that before you go out and buy any investment, the first thing to check is whether it’s covered by the FSCS. If it’s not, this doesn’t necessarily mean that you shouldn’t invest in it, but it does mean that the potential return that you expect to see should be significantly higher to reflect the increased risk that you will be assuming.

In other words, not only do you have to contend with the usual market risk of the investment falling in price, but you also have the added risk that the company that you are buying the investment through may fall into bankruptcy (even if the investment is doing well!).

See you on the dancefloor

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The good news is that awareness about the FSCS is increasing and a recent survey showed that more than 80% of 2,000 consumers questioned said that they were significantly more confident in dealing with a firm that was protected.

I am also glad to say that the FSCS is now considering changing the levy so that it is risk-based which will help matters hugely in my opinion. After all, if a firm is dealing with high risk products such as CFDs or if it has a track record of regularly receiving a high number of complaints, then there is an increased likelihood that this firm could fall into trouble in the future and will need bailing out.

If that’s the case then it would make sense for that firm to pay more into the pot now in case that happens. That’s right, it’s back to risk and reward again.

Just like members of a nightclub in the West End – if they are known to be troublesome, rowdy or just a pain in the back side, they should either have their membership completely revoked or have to pay a damn sight more to get in.

That would be make life more bearable for everybody else.

See you on the dancefloor.

Ranjeet Singh

London Stone Securities


Comments (1)

  • Mike Walters says:

    Sensible stuff, Mr Singh. But what about those tipping websites which are not registered with the FCA, escape regulation, and pay no fees?

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