Wednesday, March 25, 2020

Many “Experts” are Wrong about Risk

COVID-19 has brought a stock market crash and widespread unemployment, two things that often go hand in hand. None of the specifics of this crisis were predictable, but it was inevitable that the stock market would crash at some point. Now we have a vivid picture of what is wrong with a lot of financial advice.

I frequently argue with bloggers, financial advisors, and others about mortgages, borrowing to invest, and emergency funds. Some so-called experts say it’s fine to max-out your mortgage to invest more in stocks, or borrow to invest, or plan to use a line of credit instead of having an emergency fund.

Imagine what it’s like to have huge mortgage payments without a paycheque coming in. Sadly, many people don’t have to imagine. Those who use leverage to invest in stocks are looking at 45-60% losses or more, and they don’t know if it’s going to get worse. In these circumstances, an emergency fund helps a lot more than piling up more debt on a line of credit.

The problem with most thinking on these subjects is that people imagine normal circumstances. You don’t need an emergency fund when things are going smoothly. Borrowing heavily for a house or stocks works wonderfully when the economy and stock markets are running well.

Many experts do elaborate calculations to prove that you’ll end up with more money if you keep a big mortgage, use leverage, and fail to keep some cash in a savings account. During normal times, these strategies do give an advantage. It’s times like now when the cost of being unprepared is so high that it overwhelms this advantage. When you’re forced to sell at huge losses to get money to live on, these losses are permanent.

Does this mean we should all push to eliminate all debt and ignore investing? Absolutely not. Balance is key. When people ask whether they should pay down the mortgage or add to retirement savings, the correct answer is usually to do some of each. Few people are cut out for leveraging their investments, and all of us could use some cash in a savings account just in case.

It does no good to blame people who have been seriously harmed financially by this crisis. But the truth is there are steps each of us can take to be better prepared. It’s too late to prepare for this crisis, but there will be another crisis, and it will come during good times when we least expect it. Limit your debts to amounts you can handle during bad times, not just good times.


  1. Great article. However, I take exception to the statement "When you’re forced to sell at huge losses". If a retiree needs to sell their whole nest egg to pay living expenses now they are already in deep doo-doo. More than likely they will have to sell a small portion of their nest egg at a loss. Painful? Sure. But not the end of the world.

    Regarding leverage. If done sensibly, I think it is not a problem either in good markets or bad. I make liberal use of margin. My margin rules limit the amount to no more than one year's dividend income. I take it that you approve of "Dripping". I call my strategy "Dripping in advance". The advantages of doing this is that the dividends of the shares bought on margin contribute to the repayment of the loan. Also, I have no cash sitting around doing nothing.

    I would like to know your thoughts on that strategy.

    Cheers, John

    1. Hi John,

      I wasn't referring to a complete sale. For most people, even being forced to sell 10% of a reduced nest egg for living expenses is a painful bite out of the money they'll need for the rest of their retirement. Whether or not it seems like the end of the world depends on how close to the line they're living. I could handle a 40% reduction in available monthly spending without much difficulty, but others may not be able to handle even 10% without making painful cuts.

      If I understand you correctly, you're limiting leverage to 4% or 5%. My remarks are intended for those who borrow 50% or more of their capital to invest in stocks. Warren Buffett's advice is to limit leverage to 25% or less.

      I don't think in terms of approving or not approving of any investment approach. Each investment strategy offers a range of return outcomes for a given confidence interval. Too many investors just hope the bad end of the range won't happen, or are unjustifiably confident they will see a bad outcome coming before it arrives. If your strategy captures upside and won't leave you devastated on the downside, then it works for you.

      For most people, having no emergency savings leaves them open to a slide into debt. This doesn't apply to those with a stable income stream. So, if you're collecting a pension or spend less than the total dividends you receive, then emergency savings are less important.

  2. I have discussed this on many forums. People say if they become unemployed they will just tap their non-registered all equities portfolio. These were mostly folks who hadn't been through '07. My argument was that you have the highest chance of becoming unemployed when your equities are also at their bottom. A cash reserve, bond, fixed income allocation is absolutely necessary.

    1. Hi Ed,

      I agree. The main exception is those with very stable income. Unfortunately, many people whose income isn't stable believe that it is stable.

  3. I too argued/debated with several individuals (perhaps they were trolls) about the value of having some funds in fixed income - they told me I just didn't understand money. I do, both the ups and the downs - it's the downs that concern me.

    In just four months I'll retire, and this market downturn and its daily gyrations has helped me settle on my risk comfort level, and that is to always aim for five years worth of fixed income to draw from if needed. I’ll no longer fret over the equity/fixed allocation split. Anything over the five years worth of fixed income will go 100% into equity. I believe I will sleep well.

    I've been very tempted to sell some of that fixed income and buy the heavily discounted equity, but I asked myself why risk blowing up our retirement plan when I don't need too. We have enough already, so it's time to step back and enjoy what we've built.

    1. Hi Bob,

      Sounds like you have a solid plan very similar to mine. Most people who aim for 5 years of fixed income mean 5 years of their actual planned spending (independent of the size of their portfolios), which is fine. In my case, I have a spreadsheet that determines my safe monthly spending based on portfolio level, and I allocate 60 months of this amount to fixed income. So, my fixed-income level is actually a percentage of my overall portfolio. As a result, my spreadsheet calls for less fixed income now that my portfolio is down. So, I rebalanced back into stocks with a modest amount on Monday. If stocks keep rising, I'll have to sell some stocks again. Rebalancing is wonderful for buy low, sell high. Of course, all this only works for me because I actually spend less in a month than my spreadsheet tells me to, so when my safe monthly spending level drops, it doesn't hurt.

  4. I don't disagree in general, MJ (though I do thoughtfully use leverage, without getting freaked out by downturns).
    However, it is worth noting that e.g. VTI (using this as a simple proxy for the market, with dividends reinvested) is up 90% even if you invested at the peak in Aug 2008 (before the crash then) and sold today, i.e. had really bad timing. That amounts to 5.7% CAGR, well in excess of a HISA (if you're post-evaluating if you came out ahead investing your emergency fund) or a ~3% funding cost (for leverage).

    Those are cherry picked numbers to be about as bad as you can get. You actually ended up ahead, selling now, as long as you've been steadily invested for >= 3 years.

    None of this changes your overall message, that a lot of people have leveraged or not segregated an emergency fund thoughtlessly. But it's not as clear-cut a bad decision as it seems if you've just lived a 30% (paper) loss.

    1. Hi Martin,

      Imagine an investor 100% invested in VTI (and no emergency fund) who lost his job just before the bottom in March 2009. This investor's portfolio suffered permanent impairment because he had to start selling at the bottom to keep his family afloat. This investor didn't get the full benefit of the 90% return to date. An investor leveraged 2:1 would have been completely wiped out in March without having to lose his job. It;s not just the endpoints that matter; you have to be able to survive all the way through.

      Given your skills and training, I don't doubt that you can use leverage thoughtfully. But it's a dangerous game for all but a few.

      I often say people should have a plan that leaves them OK if they lose their jobs at the same time as stocks crater. Most people need more concrete rules such as no leverage, have an emergency fund, and pay your mortgage down while you build retirement savings. Some people's circumstances make it possible to break one or more of these rules safely. However, I doubt most people's ability to do this analysis correctly (you are an exception). A shocking number of people flatly deny that they could possibly lose their jobs, and they just hope stocks keep going up.