When it comes to investing in shares there are two main types of risk – market risk and credit risk. The ‘market risk’ is the risk of the stock market and that can be mitigated through sensible investment strategies including using options, futures, inverse ETFs and so on. The market risk is therefore something that everybody knows about, and it is what investors are completely pre-occupied with when they think about risk. However, there is another type of risk which is much worse than market risk and that is ‘credit risk’. The reason that it is worse than market risk is that it won’t just affect your portfolio by say 10% or 20; when credit risk strikes it can wipe out 90% of your portfolio or even more. That’s because credit risk refers to the default risk of the brokerage firm that you are dealing with. Take Beaufort Securities for example. Beaufort was originally known as Hoodless Brennan, a company that I know very well because I worked there for many years. A few years after I left they changed name and ownership and I had heard through the grapevine that they weren’t doing too well. I also saw that the FCA had suspended their license because they were getting involved in some dodgy deals which to be fair didn’t really surprise me. Anyway, fast forward a few years and in March this year, Beaufort effectively went into administration. Yes, another one! The problem is that it wasn’t a simple administration deal where the company failed financially. Beaufort currently has very serious fraud allegations that are being investigated by the Department of Justice in the US, including money laundering charges. Whilst under the rules of the Financial Services Compensation Scheme (FSCS) investors are entitled to compensation of up to £50,000, which means that if you had a portfolio of say £100,000 you only get back half of your money. The other problem is that it’s going to take years for the mess to be sorted out and so you are probably going to be waiting for your money during which time you will lose money on inflation and missed opportunities. However, there is another serious consideration. You see, when a company like Beaufort goes into administration the complexity in winding up the company can take many years and can cost a lot of money. PricewaterhouseCoopers (PWC) has already said that they expect their bill to be a whopping £100 million and will take four years to complete! But here’s the kicker. The £100m needs to be paid from the assets of the company which means that the investors will suffer. In this case, any client who has a portfolio of more than £150,000 (of which there are 700) will expect to get a reduction or ‘haircut’ of 40% to pay for this bill. By the way, Beaufort had 15,000 clients altogether if you were wondering. Beaufort has another real problem in terms of its client base and the types of investments that it held. For a start, the company invested heavily in the AIM market and in high-risk, illiquid penny shares. These shares are largely not readily realisable and so the true value of assets is considerably less than what might be showing on client accounts. PWC initially said that assets of Beaufort were around £800million, but that figure has since been revised down to £550million. I wouldn’t be surprised if that figure is revised even lower. I would also be interested to see the impact that those AIM ‘sales’ would have on the company shares that are being sold. I would imagine investments are sold through market makers in OTC (Over The Counter) transactions but that is still likely to drive prices down so watch out if you hold those companies in your own portfolio. So, what’s the solution? Well the first thing is to re-educate yourself about everything you know about risk and what people have been telling you over the years. The whole ‘Big is best’ mantra went out of fashion after Lehman Brothers went bust in 2008; in fact, the concept was dead and buried long before then went ING Barings went bust, but most people weren’t listening. What’s important is that you check out the company that is holding your money. Has that company lost or had some of their permissions curtailed with the FCA, does it have sufficient capital reserves in place, are the funds held in segregated accounts and under what specific terms, and are there are any obvious red flags that you should be aware of? Very rarely does a company just disappear without thereby seeing some telling signs before the event. The issue is that most people don’t see the signs until after the event. And if you really want to be safe – why even take the risk altogether? One of the advantages of dealing with some independent brokerage firms is that they do not hold your money. This means that unlike most of the larger firms, in the hopefully unlikely event that your brokerage firm falls into financial difficulty or does something stupid like Beaufort did and lose their license, your money will be 100% protected because it will be held by a third-party custodian.