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Investing Money: Can You Buy Insrurance To Protect Your Investment?

On the window of your bank, there is almost surely a sign saying that it is “FDIC Insured”. This means that no matter how terrible investments your banks makes you won’t lose your money as long as you’re under the limit–now, $250,000.

Of course, there are other concerns about saving your money in the bank. Foremost among them is that you are probably getting returns of roughly 0%. With the yield so incredibly low, and just as low on other safe assets like treasury bonds, you may be itching to move your portfolio up a weight class or two and begin to invest in riskier assets like corporate paper, commodities, and the stock market. Or if not that risky, at least towards mutual funds with riskier targets–anything for a positive return!

But then you encounter a dilemma: while rewards are nice, risk can be stressful. As we learned in the recent financial crisis, mutual funds aren’t safe. Is there anything that can be done to protect your investment? Is there any peace of mind like the FDIC offers to savings accounts?

The FDIC

First, a note about how the FDIC works. “FDIC” stands for the Federal Deposit Insurance Corporation, which sums up its main job: to insure your deposits. It does this not by charging you premiums like with your other insurance policies, but by charging the banks that it regulates. This means all banks but not all bank-like financial entities. If you’re in a bank like Wells Fargo, or a local bank like “First State Bank”, or a credit union set up by your employer you can rest assured: the FDIC has your back (and your bank).

In the event of a bank failure (like the one that gripped my credit union a few years ago), the only thing likely to change, from your perspective, is the logo on the branch. My credit union went belly-up after making some loans to Florida developers that the developers were unable to repay. When the credit union ran out of money, the FDIC came knocking on a Friday night after closing. By Monday, they had sorted everything out and transferred ownership of the bank to another credit union willing to take it over. The new credit union got the old one’s assets, and if they weren’t enough to cover the liabilities then the FDIC covered them.

What about my investments?

The short answer is: no, your assets are not protected. Now, there is one major caveat: if you make an investment through a brokerage or financial planner, that brokerage may have SIPC coverage. “SIPC” stands for the Securities Investor Protection Corporation. The acronym even looks a bit like FDIC, so is it similar?

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Yes and no. It does provide a measure of insurance, but only in very special cases: if your brokerage goes bankrupt and its remaining assets are unavailable then the SIPC will help to retrieve them and return them to investors. Critically, you the investor still bear any market risk.

An example might make this more clear. If you invest through a brokerage in 10 shares of Apple stock, and Apple stock craters, the SIPC cannot help you. However, if your brokerage goes bankrupt after the Apple stock craters, then the SIPC can help you recover your 10 shares–but they will only be worth what they’re worth on the market, not their original value.

In real life, the SIPC has helped to return part of the money that Bernie Madoff collected through his fraudulent activities. Unfortunately, only a bit more than half has ever been found–showing the limits of the SIPC.

So how can I insure against losses?

Not very easily! The best “insurance” strategy is to (1) buy and hold while (2) diversifying your assets. This means to buy a wide range of assets representative of the whole range of the economy, both foreign and domestic, and to not buy and sell as individual stocks do well but to avoid fees by just holding the stocks for the long haul. This helps to insure against the risk that a particular company, country, or asset class does badly. However, it has limits: what happens if the entire economy does badly, like during a recession?

One option is to buy a “put option”. Buying a put means you are entering a contract with another investor or firm that says that you have the right to sell them a particular asset on a particular future date at a pre-set price. So if you buy an Apple share at $700, you can buy a put at $600 for a particular future date and this means that, if Apple drops to $400 that you can still recover most of your money by reselling it at $600. Quite a valuable option, just in case–especially because you can buy puts for broad and diverse assets like a stock market ETF ensuring that you are insured against broad market losses. A good deal!

Of course, like normal insurance, you have to pay a premium for this option–even if you never exercise it. If you buy the $600 Apple put but the stock price just keeps going up, you’ll never exercise your option and you’ll be out however much you paid in the first place. Still, to buy that peace of mind just might be worth it.

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So on the whole, the answer to “is my investment protected” is: no. Investing involves taking risks, and that’s just the way it is. However, there are certain situations that the SIPC can help you with, and if you want more protection you can always buy a put. In the end, whether it’s worth it is up to you: take the risk and the rewards, or play it safe and buy a put.

Category: Financial News

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