Sunday, September 2, 2007

Smith Manoeuvre Review...September 2, 2007

I'm still reading the book and reviewing some comments on other blogs. It took me awhile to understand the basics. Not because I am older, and not because I am new to this kind of financial stuff, my resistance goes much deeper. It is contrary to my basic emotional programming. I guess I also thought that this sounds too good to be true.

I must admit that I am still trying to "get use to the idea". It makes a lot of sense logically and mathematically but like most everyone else I have been brain-washed with the working-class belief that debt is bad and that we should run away from it as fast as we can. Our beliefs come from our parents, friends, relatives, books and the media. Were all driven by fear. When I read other posts on the SM I know I am not alone on this issue.

Smith makes some excellent points beyond just using leveraging. That when it comes to investing in things that go up in value such as equities or real estate, "time is our friend". That is not a new concept, I have "know it" for many years. But Smith has found a way around the "big rock" in the stream, he shows us a way that we can overcome an imaginary obstacle, like the migrating salmon, we can jump over it. He gives us a solution that we never had before. It is positively brilliant.

It then follows that to wait "to invest", until the mortgage is paid off is not the best course of action. It is a "missed opportunity".

The reality of it all is that in order to become financially independent and retire at an early age, we need to own our own home and own other investments as well.

The SM is much more than just leveraging to buy investments. Smith also demonstrates the benefits of selling current investments like CSBs, Term Deposits or equities, using that money to pay down the mortgage, then borrow it back to re-invest. Many of us have a mortgage and money invested in other things at the same time. I was in that position for a couple of decades.

By simply re-arranging our financial house to take advantage of the tax benefit, we can keep our total debt the same, own all the same stuff, and get a big tax refund on top of it all. The tax refund can be used to pay off the mortgage sooner or to buy more investments. One's dollar level of debt never goes higher than the original size of the mortgage. And, with inflation, that debt actually reduces over time. A debt of $100,000 today is really less than a debt of $100,000 ten years ago. So one's debt level and amount of leverage actually reduces over time using the SM.

What about our fears...what if a bear market occurs? What if interest rates rise? These are excellent questions and I think one needs to go into the SM with eyes wide open and with "an emergency plan". Having an emergency plan reduces stress.

I don't know if my emergency plan ideas for the SM are the best ones, but here are a few initial thoughts.

Emergency Plan Ideas
If interest rates go crazy, like they did back in the early 1980s - and mortgages go above 20 percent, what can one do with leveraged investments? I can think of several options.

Owning equity investments, in addition to one's home, is not the same thing as owning a more expensive house. You can't sell half of your home quickly, easily or conveniently. In comparison, with the SM you have more control. Equity investments can be easily sold to reduce the amount of leverage.

Using the SM one owns the equity investments free and clear. They are not "bought on margin"(the old scary method) so you will never see a margin call that forces you to sell anything during a market crash. You won't be tempted to jump off a 10 storey building. You will therefore always have total control on the degree to which you are leveraged.

When and if it happens, you will have to weigh the pros and cons of selling equities and losing the tax refund. Higher interest rates will also bring higher tax refunds to your door to mitigate the situation. It may come down to whether or not one can meet higher monthly payments. Keep in mind that interest rates don't go from 6% to 20% overnight. You will have some time to consider your options.

During a long bear market one could sell some equities in the SM leveraged portfolio and replace them with interest paying things like Term Deposits, GICs or CSBs. During periods of high mortgage rates, these things would also be paying much higher interest rates. I can recall getting in-the-order of 18% on term deposits back when mortgage rates went above 20 %.

Another option may be to lock into a fixed interest rate loan for the investment account.

Smith also discusses the option of capitalizing interest. CI means borrowing more to pay the interest. Doing some of this would also be a way to control monthly payments.


FourPillars said...

I wouldn't count on that escape plan being available when you need it. If interest rates go up then it's pretty likely that the equities will go down in value. If you sell the equities at a loss then the maneuver has failed.


Canadian Money said...

I compared interest rates and the TSX market for the early 1980s. From 1979 to 1982 the prime bank rate was above 15%. Prime rate did not drop below 10 % until 1985. The S&P TSX Comp market continued climbing, corrected for a year or two 81-83, about 25%, then went sideways for a few years before recovering. Perhaps the stock market, normally 10% per year, did not look attractive at a time when one could sell equities and easily make 15-20% more on safe bank deposits. Even if one could make the payments, selling equities and going into safe interest rate things would have looked attractive.

Kevin Martin said...

You never have more than 75% of the value of your home invested in the LOC portfolio, so unless the market was to correct by 25% (extremely unlikely) than it is not an issue. Professional SM advisors tend to put their clients in very stable investments (my own SM plan uses 3 conservative mutual funds) with a long track record (all three of mine have been around for more than 20 years). There isn't much risk at all. Much riskier is taking twice as long to pay off my mortgage!

I don't recall that Smith mentions it in the book, but after you pay off the mortgage, a doubling of your portfolio means you can detach your house from your mortgage, which for some people will give them piece of mind even if there isn't actually any risk to their home.

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