July 12, 2007, 2:43 am

Is the Smith Manoeuvre a Secure Way to Create Wealth? Part 3

by: The Financial Blogger    Category: Smith Manoeuvre
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It’s been a while since I wrote my last article about the Smith Manoeuvre strategy (I am not counting my July update). In fact, it’s been only a month but I feel that there is so much to say about it that we can’t keep hiding this strategy to most people. I’ve seen my rank in the search engine improve related to Smith Manoeuvre Strategy searches so I conclude that there is a definite need to go further.

 

I fully understand that it is not natural to think that you will use your house to invest in the stock market. For many years we have been told to go to school, work hard, contribute to your RRSP and pay off your mortgage. While those comments are good advice, they will never make you rich. However, financial planning and discipline could bring your financial position to another level. Several questions remain around many financial techniques. I’ll try to answer some of them post by post

 

What if market crashes and I’m left with nothing?

First things first, thinking that the market will crash and your portfolio will get to 20% of your book value is irrational. Markets can crash and market will crash. However, a heavily severe correction will make your portfolio drop by 30%, maybe 40%. Nonetheless, you have to count that markets are not on a constant slop. Therefore, you have a big chance to have increased your portfolio value before market crashes.

 

I’ve seen many portfolios of people that borrowed to invest back in 2002, 2003 and 2004. As it was the good timing to invest you might say, they have 130% to 200% of their loan value in their investment account. Keep in mind that most of them are paying interest only.

 

Starting from that point, let’s say that you have borrowed 100K and your investment worth 150K today. Tomorrow morning you find out that market is crashing by 30% (which is unlikely to happen in one day but you never know!). You investment will drop to 105K. You will still have a positive return (even though it will not make you rich) after an unpredictable drop.

 

What if you invest now and the markets crash in 6 months?

 

This is a more rational fear than our previous example. As we are in a bull market for the past 4-5 years, there is a big chance that economy will overheat and that we will face a bear market. If it’s the case, you better be ready to ride the rollercoaster in your first years because it won’t be easy on your mental health.

 

You might find yourself investing months after months into stocks or mutual funds that will keep going down as you buying more and more of them. However, it may turns into a major advantage over the long run. In fact, the Smith Manoeuvre Strategy implicates regular (preferably monthly) purchases. You could then average your cost down in the bear market.

 

If you pick your investment in a buy and hold mentality, you will create a great opportunity to buy good companies at a discount price. As this financial technique is based on a long term investment horizon, you might find yourself laughing when the next bull market will arise.

 

In conclusion, I must admit that this idea of writing post about the Smith Manoeuvre was made to write 1 or 2 post about the potential risk. But the more I write, the more I find stuff to write about. Therefore, I will continue this series for a few other posts. In the meantime, please send me comments or email your question about the Smith Manoeuvre. There is nothing better than communication to fully understand financial techniques.

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Comments

I think your comment about mental health is pretty appropriate. Investors have to ask themselves the question of whether they are willing to handle a lot more stress if they are leveraging through a bear market.

As for corrections – in 1929 US stocks lost 90% of their value. As Bernstein points out, if someone who retired at the peak of the market was 75% invested in equities, they would have been fine as long as they stayed invested in equities. Although I feel reasonably well equipped to handle a bear market, I honestly don’t know if I could handle a 90% loss all that well.

Another stress inducing situation is a long term bear market – what if the market loses 10% for three years in a row – that type of market can be very damaging from a psychological point of view.

I use leveraging in my portfolio but one issue that never seems to get addressed about the SM is controlling the amount of leverage. It appears that the SM leverage amount is whatever you can borrow against your house regardless of your ability to pay the costs if things don’t work out.

Mike

by: The Financial Blogger | July 12th, 2007 (4:01 pm)

FP, I agree with you regarding a drop of 90%. I guess that working on the 22nd floor, could save me a lot of worries (If I jump over the window, I will not have to worry anymore :wink:).
Seriously, it could be quite painful.

You point on the amount to leverage with the SM is interesting also. Technically, you should do it gradually over your mortgage payment. However, you are right as the amount borrowed will become significant at one point!
FB.

I’m not familiar with the “SM”. Can you explain how the loan becomes tax deductible? CRA is pretty specific that loans used for RRSP contributions are not tax deductible. Thanks.

by: The Financial Blogger | July 15th, 2007 (7:24 am)

Hi Thomas,
CRA does not allow individuals to deduct interest paid on RRSP loans. When you borrow money in order to earn income (which is not the case with RRSP) you are allowed to deduct the interest. Please visit this address for more information :
http://www.cra-arc.gc.ca/tax/individuals/topics/income-tax/return/completing/deductions/lines206-236/221/menu-e.html
Cheers,
FB.

Hi FB,

One risk you did not talk about is disability. Getting sick or disabled is much bigger …if you only get say 60% of your paycheque. Your readers should review their disability insuarance coverage at work or consider critical illness insurance.

regards,

Brian Poncelet, CFP

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