With your allegory, are you trying to steer us in a particular direction?

Did the first farmer have to comply with Sarbanes-Ox regulations?

I’m not sure I saw a recommendation from you as to the proper course of investing. One can always come up with a hypothetical scenario in which a strategy does not work.

Even though I’m (hopefully) 10 years from financial independence, I am planning to need another 40 years of income after that point. Although I am very highly invested in equities, most of my investments are dividend payers. I hope that this provides some stability and, ideally, a sufficient income stream that will not require the disposition of any capital.

Great points. We think one of the most costly mistakes made by most people is to invest much to conservatively when they get near retirement. They still probably have 30+ years in front of them, so having too little in equities can cut retirement income by a huge amount (and cost more tax).

If we do end up with higher inflation, bonds can be quite risky. They have historically been far worse at keeping up with inflation than stocks over the long term.

The benefit of a financial advisor is often far more obvious after you are retired, since having an appropriate asset allocation and planning for the least tax (such as planning around tax brackets and avoiding all the clawbacks) have easily quantifiable benefits.

Ed

assuming that person is ‘Average’ – retirement age around 62, life expectancy of 90 ish – and will be looking forward to a roughly 30 year retirement time frame, i would think he would rather have a prettty good idea about what interest rates are going to do, or a plan to invest and draw sufficient income no matter what they do, because a fixed income strategy in a rising cost retirement is not a conservitive plan at all. it is far more ‘risky’ than investing in equities whose dollar value on a piece of paper will fluctuate up and down with regularity.

finally, it is just an observation that a person who has not been advised of this fact, and has not been helped with a plan to allow for it, is the same person who when shown a potentially excellent strategy on how to increase net worth and future income potential, would make the assumption that an advisor is only – or mostly – showing this in order to make a 1% commission on the assets invested, if someone is shown and helped through a strategy and a Plan that increases their net worth by, for example, $500 000, does it matter that they compensate the person responsible for this increase. unfortuneatly, this is common for DYI investors who always focus on MER’s and doing things the cheapest way they can find.

just some thoughts.

As I get closer and closer to my retirement, I will indeed abandon equity investing and switch to fixed income.

Bad means that I actually make less money that I paid in interest and am left with not much to show for my retirement. The S&P500 not having a loss is a big difference from doing better than my interest costs. Interest rates are all good and low right now but they got pretty high in the eighties.

With an RRSP or TFSA, I don’t have to worry about interest rates and even with a zero return, I still have the initial savings that I put in.

Aolis

I agree with your comments about risk.

However, if you are going to avoid any strategy where you could end up way behind, should you also abandon equity investing?

What do you mean by “if it goes bad”? Do you mean going to zero?

The risks of both equity investing and the SM decline over time. For example, the S&P500 has never had a loss over a 15-calendar-year period (including during the Great Depression) and has never made less than 5%/year over a 25-calendar-year period.

If you have a solid investment strategy, the ability to maintain your payments long term, the risk tolerance to stay invested during major declines and the discipline to avoid behavioural mistakes, then the worst-cases scenario is usually manageable and is not “going to zero”.

The risks do decline a lot over long time frames (eg. at least 15-20 years).

Ed

“if it loses money, clearly I am way behind.”

I’m going to retire regardless so I really shouldn’t be choosing a strategy where I can end up way behind.

Risk tolerance isn’t just how aggressive I feel, it also depends on my ability to absorb loss. If I am already contributing the maximun to my RRSP and TFSA, then if I do leverage my house, the debt is only a fraction of all my investments. If it goes bad, I can pay it off from my RRSP and still have retirement funds left over.

Aolis

RRSP and TFSA are clearly better than SM or leverage? That depends on your assumptions, your risk tolerance and your time frame.

Leverage magnifies the gains and the losses. If you invest effectively for a long time frame and can tolerate the risk, leverage has a very good chance of making much higher returns than RRSP or TFSA.

For example, if you have $4,000/year of cash, you could contribute it to your RRSP and get a $4,000 tax deduction. If instead you borrow $100,000 to invest @4%, you have payments of $4,000/year and have a $4,000/year tax deduction, but you have $100,000 in investments, not just $4,000.

If the $100,000 makes a good return, then clearly I am way ahead (after interest costs and tax), and if it loses money, clearly I am way behind.

The 25-year rolling returns of the S&P500 since 1871 have ranged between 5.0%/year and 17.4%/year. So, if you do this as a 25-year strategy, your odds are quite good.

Also, when we compare the SM to a TFSA, the SM normally creates refunds each year, since the tax deduction on the interest is usually more than any tax on the investments, especially if you invest in tax-efficient funds and don’t sell.

RRSPs provide a tax-deferral and TFSAs are tax-free, but leverage and the SM normally create tax refunds each year.

Ed

The real problem with the Smith and its variants is that they really confuse the issues of long term investing and paying down the mortgage. On one hand, you are simply borrowing money to invest and using your house to secure the loan. On the other hand, you are moving money around to try and get a tax deduction on a portion of the interest you are paying on your mortgage.

In the first case, you should be putting 18% of your salary into your RRSP and $5K into a TFSA first. In the second, the interest rate is so low right now and has been for some time that the tax savings are not very substantial but the risk is still high.

In the examples, most of the difference comes from assuming that the leveraged investment does well. You are going to be in alot of trouble when you decide to sell your house after a 20% drop in the market. That is a probable outcome yet easy to ignore when it is twenty years down the road.

In my mind, the real purpose behind the Smith idea is to get people to consider leveraged investing, who might not otherwise. The idea is hidden underneath a blanket of paying down a mortgage. However, RRSP and TFSA are clearly superior investment choices and the tax deduction on the very low interests rates we have now is negligible.

The real catch to all this comes when the financial advisor proposing this plan starts suggesting investments that are profitable to themselves. Suddenly, you are investing money you that you didn’t have before and the advisor is making 1% of that each year.

With a life insurance policy, you have to pay the insurance premiums. The amount you can invest is based on the size of the policy. Unless you need life insurance and will need it for the rest of your life (not just till you retire), then this method is far too expensive.

Also, you would pay more in MER for the principal guarantee after 10 years. Since the markets are so rarely down after 10 years, this extra MER is probably not worth it.

If you exclude the Great Depression, the last 10 years are the only 10 calendar year period in which the S&P500 was down since 1871. That’s 1 time in 130. To protect against this rare chance of being down, you have to pay a higher MER of .5%/year.

If instead you have high quality investments and have faith enough to stick with them when they are down, you have about a 99% chance of beating the investments you would buy inside the insurnace policy.

This probably becomes 100% once you include the insurance premium, which can be very high for the UL policy you would need to buy.

You can of course use your equity to invest in more real estate. However, growth of real estate has been far less than the stock market. The average house in Toronto in 1977 was $65,000 and was $379,000 in 2008. That’s growth of 5.9%.

The TSX in the same period has grown 10.5%. If you had invested that same $65,000 in the TSX in 1977, you would now have $1,430,000 and could buy 3 1/2 houses.

The rent generally only creates positive cash flow if you have equity tied up in your home.

Virtually every story I’ve ever heard about someone making money in real estate was actually a story about leverage working. Almost always, it is a good return resulting from the leverage effect on a slow-growth investment.

Most people are not aware that you can leverage similar amounts in faster growing investments. This can give you a far higher return than rental real estate over time, without the PITA factor of renting – that is if you are comfortable with the risk level and can stick with your investments long term.

I was heavily into rental real estate decades ago until I realized that I could make a lot more money without all the work.

Ed

Although the very “policy” you describe is not available in Canada, there is a variant of it, with a floor of 7% and no ceiling. I use this myself. All else is the same.

There is no reason why an other property could not be used for investment, except that the real estate values are slow to rise in value, in some markets it is stagnating for many years. The other thing is that it prevents diversity although that would be desirable in any investment strategy. So, I would suggest to have a property, but have also some equity and some dividend investment as well.

2) Isn’t it better to use your equity a second investment property anyway? (rather than invest the equity in the market). Given all the investment steams investment property gives you can have renters paying several properties for you. OPM my bretheren!

I’ll have to admit, I read your first post, then the most recent, skimmed some of Ed’s comments – For some reason I had the impression that there was a distinct possibility of uncertainty regarding your employment, and the possibility of moving also.

Given those assumptions, I thought there was a chance you might have to liquidate in the near-term – of which you obviously understand the risks.

I suppose my point is that instead of deciding to go all in, or not, you can take a balanced approach. Since it sounds like you had not been investing much in equities in the past, you probably have a somewhat limited feeling for the sting of watching your portfolio drop by >40%. My understanding is that you feel you would be able to stomach the volatility – but its impossible to know until you are tested.

So to your example of the 10k, you might have sitting around. Instead of using all of it for SM (i.e. paying into your mortgage and readvancing the HELOC), why not (i) pay $5k into the mortgage and borrow $5k for SM – put the remaining $5k into the RRSP and reinvest the return (either directly, or using the SM).

This ‘partial’ strategy would mitigate some risk – offer exposure to leveraged investing and the potential rewards, give you some time to assess the ability of your advisor, expose you to the stock market, pay down your mortgage, deduct taxes from RRSP contributions and the HELOC.

This does mirror my current approach – First, I do fully contribute to RRSPs. Then I apply the remaining funds (over the year) and the tax rebate to my non-registered portfolio then mortgage at 70% to 30% rate. I have seriously considered the SM (a partial version anyway) – but would like for the World economic situation to settle down and stabilize.

“If you don’t do the SM and invest – if you lose, you can cut your losses there. With the SM – not only is there a possibility of eating those losses, but also getting stuck with a nasty loan.”

If I can make reference to Ed’s advice to me earlier, these are the words of an investor with a shorter term horizon for investing. I will not know if I won or lost for several years. If I invest right now I fully anticipate I will be on the downside for 2 years or so, but the investment certainly doesn’t end in 2-3 years. In fact cashing out in 2 years or so is what I think Ed is cautious of me doing. He’s probably seen tons and tons of people do that. Cutting the paper losses is a short term view. I’m assuming the losses will not continue for 15-20 years (assumption from historical returns on stock exchanges). How would I get stuck with a nasty loan? Yes, if I cashed in early the leveraged investments would greatly amplify a loss. Over the long haul I believe I will be ’stuck’ with a significant gain.

I’m viewing the SM in the same way as a typical couple views their house. If the value of their house dips, they don’t sell, they need a place to live for the rest of their lives. Sure if my portfolio drops in value I won’t sell, I still need a pension for the remainder of my life. The average couple may change houses as their needs change, and yes over time the fund manager/financial adviser, would alter things in my portfolio.

So let me ask you this, in order for you to defend your position: If you had 10K and 10K left of RRSP room to contribute, and No SM in place at the time, would you put it into RSP in Investment A, or would you use the SM and only leverage $10K of your home’s equity and invest the 10K in investment A ? Obviously there are benefits and drawbacks to each.

Earlier, I mentioned how I ask in several places and look for discrepancies, you seem to lean towards RRSPs first, while Fraser Smith leans the other way.

If I were you, I’d be a little careful treading so quickly into the SM. From your posts, it sounds like you don’t have too much experience with investments – so my question is why would you borrow money to buy investments? Instead of making such huge prepayments, invest your earned money.

My view of the SM is that there are two significant risks. One, you mention is of the holdings themselves, if the investment vehicles selected have decent growth and will yield some form of steady and appreciating income (whether interest or dividends or capital gains).

The second risk comes from the leveraging aspect. If the above falls through (i.e. dividends get cut, you suffer capital losses, inflation overtakes and eats away at fixed income returns) – then you are left with a significant loan.

If you don’t do the SM and invest – if you lose, you can cut your losses there. With the SM – not only is there a possibility of eating those losses, but also getting stuck with a nasty loan.

If sounds like you have significant earning potential – so if you can bank $62k to top up your current mortgage, why don’t you just split that in this coming year, start a solid investment portfolio (simply by maximizing your RRSP contribution you have thousands of $ returned/saved every year in taxes) – and if your advisor can prove their ability, then and only then consider the SM.

Good luck!

This used to involve going into the branch for an adjustment each month.

I gather from the opinions on this blog, the Scotiabank STEP is not a well suited product for SM. *It would appear that it has improved.* But that is not necessarily to say it’s a good fit with SM.

I’m using STEP because I’m halfway through a closed term with them already, because I was approved for 80% of my 440K appraised house 2 years ago, (vs 65% of the current value of 400K) and because my LOC is at prime (instead of prime +1, which appears to be the going rate).

Ed, Thanks for your feedback. I do wonder if you’ve arrived at your suspicion of non suitability for SM without sufficient evidence. In the past few days I have researched a great deal on leveraged borrowing. Here’s more.

First, regarding point about my knowledge, I believe I’m much more knowledgeable around investments than you suspect (Bachelor of Commerce degree – book knowledge granted), and yes I’d agree that I was not using terms dividend & equity properly. ‘Income’ 25% & ‘Growth’ 75% would have better terms. I do admit I’m not nearly knowledgeable or experienced enough to put together a proper portfolio, nor do I wish to.

The financial planner’s job is to select suitable investments/funds, develop a plan etc. My job is to determine the proper financial planner, and to follow his plan.

As you pointed out, I do carry risk by the very nature of being single, and with a variable income. For this reason, I’m very careful with my finances, I make substantial prepayments on my mortgage when I can (62K last year) and take comfort in knowing that I can ’skip’ multiple mortgage payments if I’ve made doublepayments or prepayments in the same calendar year. Also, I have secondary income, that pays 75% of my mortgage. I do anticipate that a financial plan suited to me would address variable income issues, and likely I’d end up sacrificing some long term growth to mitigate the this risk. I’ve been self employed in oil & gas consulting for 8 years, and I think I put in safeguards to address variation in income.

I’m somewhat caught. I wish to establish distance between myself and the activities of my yet to be determined financial planner. Yet, I feel a little knowledge goes a long long ways. I’ve averted huge mistakes by asking around and informing myself. I do not have the experience to know when I’m being ’sold’ a financial fund/policy/product that I’m not suited for, so I do ask more than one source, searching for discrepancies. So no, I’m not deciding what to do with the information I gather from multiple sources, I’m determining (as best I can) whose opinion is suitable and sound, and whose is suspect.

I disagree with your inclination that I may be one of the people who don’t stick it out over the long haul. Here’s why: Unfortunately, I did witness someone leverage their house who was very risk adverse, she was in her 60s, her time horizon was intended to be long, but she bolted, and liquidated her assets with a small loss. If I go into the SM, I do so with evidence that those who react/invest/divest based on natural market fluctuations are have a high likelyhood of being hurt. I’m a believer in DCA, and long term, buy and hold strategy. I feel that I’m extra likely to tough it out when the markets are bearish, due to what I witnessed.

Ed I feel the SM is not where the risk lies. The risk lies in the investments themselves. I’m cautious about talking myself into something that I should steer clear of. I’m also aware that I need to start to establish a pension plan, as I won’t have an adequate one on my own. If I go ahead with SM, I do so to establish a pension. I do take stock in your comments about my suitability. If you truly think that SM would be a bad decision, I admit it would weigh heavily on my decision. This is why I’ve given you extra details.

Downsizing your home in the future should not be a problem, since you presumably would be buying a new home for less money. You can take the difference and pay your mortgage/HELOC down to the point you need or can finance on the new home.

The issue with moving is mainly if you move to a more expensive home, since you need to be able to make the down payment.

From all your comments, the SM might not be right for you. You seem quite concerned about the markets, which makes me wonder if you would be able to stay invested the next time your markets go down.

You seem to be trying to get info from a bunch of places and then decide yourself what to do, but you do not sound very knowledgeable about investments. Dividends would also come from equities, so being 75% equities and 25% dividends would be the 100% equities.

If a prolonged period of no income with a career change is possible for you and since you are single, this is also an issue. You need to be able to maintain the SM as a long term strategy to be confident it will work for you, which means it is best if you are confident that you will always be able to make your mortgage payment.

This can be dealt with, however, if you have an adequate emergency fund and protecting your income.

This may make sense as a calculated risk, however, since all you need to do to maintain the SM is to maintain your mortgage payment. Even in a worst case scenario if you cannot make your mortgage payment, you could always draw on the investments to help make your mortgage payment. This would affect the tax-deductibility of your investment credit line, but is still an option in an emergency situation.

Ed

2) Although applying for credit does lowers your credit rating in general, once you have your LOC, you qualified for it, the only thing that matters is your payment habits. Pay your monthlies on time and your rating will be fine.
That in turn will help you when you buy a second house.
If you just change your house for an other one, as long as LTV and credit rating is ok, you will have no difficulty to carry with you your SM Plan. Nor would it be necessary to liquidate any investments.

I do note that there are side effects to this manoeuvre.

1) Should a couple start SM with a larger house, then find their house has become an empty nest and decide to downsize, they may need to liquidate a portion of their portfolio earlier than they had expected, thus the timing of their house sale will also be when some of their portfolio may need to be sold. For me, single, younger, with a larger house appraised at 440K – Heloc based on 80%, a mortgage of 250K, and 100K LOC, (350K Global limit) if I moved I would probably have to take a new mortgage on a smaller house, (using Stated Income as I’m self Employed) and therefore the institution would lend only 65% of appraised value. I would have to liquidate much earlier.

2) Credit Rating, This one is a bit of a mystery for me as I’m uncertain how much this is affected by a maxed out LOC. Some people may not utilize the entire LOC, only using 75% or so, but since the LOC can’t be used for much else except investing (due to the CRA necessity of interest tracibility) , you give up a lot to preserve the credit score.

Still working on a solid investment portfolio. Looking at 25% of portfolio in dividends. Remainder in Equities. In the immediate near term I’ll leave the equity side alone. I need more help in this investment side. The advisors that I’ve met so far seem to more skilled at tax, than at well researched mutual fund setups.

thoughts?