Saturday, September 1, 2007

The Smith Manoeuvre Review...September 1, 2007

I'm currently reading "The Smith Manoeuvre" by Fraser Smith, 2002. ISBN 1-55369-641-7.
So far I'm finding the book quite good and easy to understand. It is a quick and easy read if you don't stop to check the math. Theoretically, in hindsight, had I discovered the SM back in the mid 1980s, when the author first invented it, and had I implemented it on my mortgage, and had I understood the market, as much as I do today... back then... then I would be a lot richer than I am now. Hindsight is 20/20 and there are a lot of "ifs" in this statement!

One of my initial concerns was that the SM required one to take on additional debt. This doesn't seem to be the case. As I understand it, for the Plain Jane version, one's total debt never exceeds the initial amount of the mortgage for the life of the mortgage. That is less scary than taking on a mortgage plus additional debt for investments.

I also like the fact, that for young people, the investments grow slowly over time, giving one time to adjust to the reality of market volatility. It forces one to "dollar cost average" into the market. Even if one understands very little about the market, dollar cost averaging builds in a safety factor against really dumb moves. But be very careful here....dollar cost averaging alone is not enough to save one from big stock market mistakes.

The SM depends upon using financial leverage to help one grow their net worth over time. However, financial leverage can also make a bad move much worse. In general, the SM alone does not guarantee success and it could make things much worse.

When applying the SM one should have a solid understanding of how the stock market works and the historical pitfalls. "The Four Pillars..." book is a good primer on this issue. In particular, learn about the historical mistakes that keep repeating themselves with each generation. Each and every time market participants think "this time is different".

A worse case scenario for the SM would be where one invests a very large "lump sum" into the market, in the wrong (high risk) investments, at the worst possible point in time. This could happen with a mature SM account, where the owner gets caught up in a buying mania, sells and buys a large sum of investments within the portfolio, or where one begins the SM with a large lump sum borrowed on a home that had been owned free and clear before the SM.

For example, if an investor (gambler) made a lump sum purchase of stocks such as Nortel (NT)or Cisco (CSCO) or even the entire Nasdaq Index near the peak of ~5000 in late 1999 or early 2000. This was a classic case of "irrational exuberance" when many people treated the market like a gambling casino. Then, during the subsequent severe bear market, the investor/gambler "lost heart", gave up on the "buy and hold" philosophy because the pain was too great, and sold it all at a large loss. That loss would then be in the form of debt, debt that the investor/gambler must pay interest on until it is paid off.

One redeeming fact is that the interest on that debt is all income tax deductible. Also, if the SM had been in place for a number of years with significant profits accumulated, prior to the dumb mistake, these profits would help offset the big error.


FourPillars said...

Although the debt doesn't increase from the original amount, it certainly becomes larger relative to the person who is not doing the SM.

Normally the mortgage would get paid down over time whereas the SM total debt never gets paid. Deductible debt carries less interest rate risk than non-deductible debt so the interest rate risk does go down over time - but again the risk is still higher than for someone with no SM.


ps I left some more detailed comments on this very subject over on Canadian Dream's blog - he did a post on SM last week.

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