Thursday, September 13, 2018

Smith Manoeuvre Risk Assessment

The Smith Manoeuvre is a tax-efficient way to borrow against your home to invest more in stocks. This increases your potential returns, but also increases risk. Periodically, it makes sense to evaluate whether you can handle the potential downside.

It’s clear that if you can follow the Smith Manoeuvre plan through to near retirement without collapsing it at a bad time, you’ll end up with more money than if you hadn’t borrowed to invest. The important question is how likely you are to be forced to sell stocks to pay your debts at a bad time.

It’s easy to decide you’re safe without really considering the risks. I find that employees, particularly in the private sector, underestimate the odds of getting laid off. Most of the time, they’ll say it can’t happen. But it can. You can lose your job, stocks can fall, real estate prices can fall, and all 3 can happen at once.

In fact, a single event could trigger all 3 bad outcomes. Anything that could cause stocks to drop 30% could easily cause sky-high Canadian real estate prices to drop significantly as well. The resulting pressure on businesses could lead to layoffs. This isn’t a prediction; it’s just one possible outcome out of many. This raises the following question.

Could you keep your financial plan going if the total value of your house and stocks dropped below your total debt at the same time as you’re unemployed for a few months followed by employment at a lower salary?

A gut feel isn’t really an answer to this question. A real answer comes from looking at numbers, including your essential spending, available cash, and the amount of reduced cash flow.

If your answer is that you couldn’t survive a scenario like this without selling stocks or your house to make payments on your debt, then you should consider reducing your leverage now (which is just a fancy way of saying you should sell some stocks now to pay off some debt while stock prices are high).

If your answer to this question is that you’d be fine in this scenario, or at least you could come out of it with minimal damage, then good for you. If your answer is that such a bad scenario can’t happen, then I wish you luck because it did happen in the U.S. in 2009.

3 comments:

  1. I've come to realize that building a portfolio around the goal of never having to sell anything is too conservative for me. I would rather take the additional opportunity as long as it works out most of the time.

    I've had one instance where I had to sell off 10% of my portfolio, and a couple more where I did a smaller sale to make myself more comfortable with a temporary change.

    The timing worked out well in those instances. But if I had to sell 10% at a time when I took a 40% loss, I still think that's better than having a much smaller portfolio by avoiding that kind of situation. Given a few years of growth the gains could be even more than that 4% I would lose from bad timing.

    It could be worse than that of course. It's hard to imagine that I would have to sell a large portion of my portfolio since I would be cutting back on expenses if it got that far and I can't see any debts being called that would amount to more than 15% of the value unless we relive the great depression. I also can't do SM since I don't own any real estate and I have seen my rent decrease in a falling market which reverses the correlation.

    I'm fully committed to basing my decisions on long-term probabilities and haven't had any real worries from volatility or headlines. I can see where behavioral considerations would change this.

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    1. @Richard: It sounds like you're making a choice with your eyes open and that your downside is limited. I know there are others who would be wiped out by the scenario I described.

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    2. The downside of real estate is that it's easy to forget your losses could be coming from an asset worth a lot more than your equity. I don't have that as much and it's a lot more visible.

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