My Own Advisor

I’ve got a bunch of debt – mostly from my mortgage.  I wish there was a way to convert this mortgage debt into a tax-deduction, you know, like the Americans can, to kill off my mortgage faster.  Sounds like fiction in Canada right?  Well, this can happen to you and me if we follow The Smith Manoeuvre.

While The Smith Manoeuvre is tricky to set up and takes some significant financial discipline to keep it going, it is perfectly legal and complies with our Canadian tax code.  I’ve been considering this approach for my portfolio for some time and a recent conversation with someone piqued my interest again, pun intended.

This manoeuvre has already been described across the blogosphere quite a bit; Google-it and you’ll find these great posts over at Canadian Capitalist and Million Dollar Journey.

Canadian Capitalist and Million Dollar Journey links:

Smith Manoeuvre Part 1.

Smith Manoeuvre Part 2.

Smith Manoeuvre Part 3.

Smith Manoeuvre Part 4.

Canadian Capitalist also reviewed Fraser Smith’s book here.

Million Dollar Journey links:

Smith Manoeuvre – Part 1.

Smith Manoeuvre – Part 2.

Should I Start the Smith Manoeuvre?

The Smith Manoeuvre Money Flow.

Million Dollar Journey also paid tribute to the late Fraser Smith here.

Smith Manoeuvre Facts and Flow

The idea is to convert your existing mortgage debt into tax-deductible (investment) debt and use the tax deduction and income, if you choose from investments made to pay down your mortgage.

To make the idea a reality:

• You need a readvanceable mortgage whereby you can tap into your Home Equity Line of Credit (HELOC).
• As you pay-off the mortgage principle, like you’re doing today, the amount of equity available in the HELOC goes up over time.  Mortgage goes down; available credit to borrow goes up.
• That available HELOC can be used fund investments.  Refer to the figure below courtesy of National Bank:

Take available money out of HELOC and invest it – preferably into solid income-producing investments in a non-registered self-directed discount brokerage account.  When you borrow money for investment purposes, the interest paid on the loan is tax-deductible.

Use the tax-deductions and investment income (e.g., dividends) to pay down your non-deductible mortgage debt.

So, mortgage debt does down; available HELOC keeps going up, as you use the HELOC to buy more income-producing investments.

Smith Manoeuvre Considerations

This type of leveraged investing is not for the uninitiated investor.  This process has tax, investment and more than a few psychological risks.

On the tax-side, you must present a clear audit trail of your investment approach in case Canada Revenue Agency comes knocking.  Simply taking money from your HELOC and using that money to invest is NOT the Smith Manoeuvre.

On the investment-side, you better ensure your income-producing investments are in your non-registered account.  Using money from your HELOC to invest in your RRSP or TFSA will NOT give you a tax deduction.  Also, be mindful, the essence of borrowed money – it must be repaid at some point.  So, make sure your income-producing investments have the potential to exceed the interest burden you are taking on.

On more of the psychological-side, you must be aware you are re-borrowing money to pay down your mortgage.  Canadian Capitalist, Million Dollar Journey and other prominent bloggers have stated time and time again when discussing this strategy, you need to be very comfortable with leveraging to perform this trick.  What happens if your income-producing investments don’t cover your loan?  What happens when house values drop and you need to move?  What if you need money in an emergency?  What happens when interest rates change and/or borrowing costs go up?  Investing is not just about buying assets it is very much about psychology and planning for the unplanned too.

You must also consider the time and maintenance this process takes.  Probably most investors who have a decent income, to perform this trick don’t need to do it anyhow.  Check out what Michael James on Money said:

“I suspect that the Smith Manoeuvre is too risky unless your income is high enough to pull you out of any problems with your investments or a drop in the value of your home. But, if your income is high, why not just go for the low risk strategy of paying down your mortgage and investing some of your excess earnings?”

Smith Manoeuvre Conclusions

The Smith Manoeuvre is tricky to set up and take some smarts to keep it going but it is a perfectly legal and an accelerated way to kill your mortgage debt while growing your investment portfolio.  For those investors ready to take it on, great stuff and I wish you well but personally I’m not ready to take this leap yet.  Although I’m very intrigued about using this strategy myself, it’s just not the right time for me.  I want to thank my brother-in-law from inspiring me to write this post and I look forward to hearing from him if, when, how and how long he intends to use this process on his own journey to financial freedom.

Have you used The Smith Manoeuvre?  Are you considering taking it on?

Want to read even more about this strategy?  Check out an outstanding post by fellow blogger The Passive Income Earner.

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A few weeks ago on my blog after Three Steps to Plan Your Portfolio was published, there was a lively discussion about risk after I suggested investors should consider answering the following questions before diving into product selection for their portfolios:

• What is my current risk tolerance for investing?  Risk, what are you talking about?

Some comments ensued and some folks suggested risk and volatility are one of the same.

I beg to differ.

Let’s take a look at some classical definitions:

(General) Risk – possibility of loss; something that creates or suggests a hazard; the chance of loss, the chance that an investment (as a stock or commodity) will lose value.

Definitions courtesy of this site.

(Financial) Risk – chance an investment’s actual return will be different than expected; possibility losing some or all of the original investment.

“A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to be compensated for taking on additional risk.”

Definitions courtesy of this site.

Financial risk usually manifests itself when assets are poorly balanced or not diversified.  In the insurance business, you avoid risk by insuring against a catastrophic loss.  For example, if you want to take on more financial risk that usually means more stocks and fewer bonds in your portfolio.  Boring bonds provide safety and thus promise less growth.  You can read an article about that on Canadian Couch Potato.  Diversification is also a hedge against risk.  Too few securities, in too few industries will increase your risk.  You can lower your risks by investing in broad market Exchange Traded Funds (ETFs) across many markets.  When it comes to insurance, many people choose to buy it to transfer the risk to someone else (for a fee).

Volatility – a statistical measure of the dispersion of returns for a given security or market index; price fluctuations over a defined time period.

“In other words, volatility refers to the amount of uncertainty or risk about the size of changes in a security’s value. A higher volatility means that a security’s value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security’s value does not fluctuate dramatically, but changes in value at a steady pace over a period of time.”

Definition courtesy of this site.

As you can see, the terms risk and volatility are not interchangeable although they are related.

What is an investor to do, focus on risk or volatility, both?

I’ll speak for myself.  As a long-term investor I’m not worried about volatility in my portfolio since price fluctuations will always occur.  If your investment plan stretches 20 or 30 years, I’d argue you shouldn’t care about volatility either.  Mr. Market will always try and trick you (or I) into selling or buying something at the wrong time.

Instead of worrying about volatility I will focus my energy on reducing risk across my portfolio through primarily good diversification and asset allocation.  I will also reduce risk by owning life insurance to offset the debt and liabilities I have.

Thinking and acting long-term, I recall the KISS portfolio from the Elements of Investing.  The authors of this book claim if you follow the KISS portfolio (Keep It Simple, Sweetheart) almost every investor will be successful.  Here are a few KISS elements:

• Save early and regularly, for as long as possible.
• Set aside a cash reserve for when “stuff happens”.
• Make sure you are covered by insurance, especially life insurance.
• Diversification will reduce your anxiety.
• Ignore the short-term sound and fury of Mr. Market; the biggest mistakes investors make are letting emotions dominate.
• Use low-cost index funds.
• Focus on major investment categories; avoid “exotics”; most investors should focus on owning common stocks, bonds and real estate (via home ownership).

What are your thoughts when it comes to risk and volatility?  Do you focus on risk?  Do you care about volatility?

Do you have other definitions of risk or volatility to share?

Thanks to Glenn Cooke for the blogpost idea.

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“Investing is simple, but not easy.” – Warren Buffett

All too often, because we’re all human and flawed creatures, we take the simple and make it unnecessarily complicated all too quickly.   For today’s post, I’m suggesting investors consider some questions to help them plan their portfolios – questions I often revisit myself.  I suggest there’s always time to get into the details once you’ve answered a few simple questions.  Don’t kid yourself.  Simple answers don’t always come from simple questions…

What kind of investor am I?

Try to answer these questions:

• What is my current risk tolerance for investing?  Risk, what are you talking about?
• Do I prefer focusing on investment growth or income?  Do I know the difference?  Do I even need to decide?

What is my investment plan?

Try to answer these questions:

• How much can I save for investment purposes?  Are saving and investing the same things?  Is there a difference to me?
• How long do I want my money invested?  5 years?  10 years?  20 years or more?  Do I know?  Why is this important?
• Can I easily explain my investing goals to someone else?  How do I know these goals are realistic?  What information am I basing this on?  Why the heck do I need goals?

What are my investment options?

Try to answer these questions:

• What investment products do I understand?  Are there investment products I do not understand?
• How comfortable am I choosing my own investment products?  Do I need someone to choose my products for me?  If so, why?

I think smart investing starts with a clear understanding of who you are first, what your plan is second and then narrowing down the options and potential solutions available to you.  If you’re struggling with any of these questions, I wouldn’t see that as a negative but as an opportunity to get some help and support from professionals.  The beauty of our human condition is, nobody knows all the answers all the time.  We’re all learning and we always can if we really want to.

I propose you understand yourself, your plan and then starting looking at investment options.  Do you agree with this order?  Why or why not?  What important questions did I miss?

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“The investor’s chief problem – and even his worst enemy – is likely to be himself.”

-Benjamin Graham, Value Investor, Mentor to Warren Buffett

Contrary to what many institutions might have you believe, investing in sub-par performing investment products is not an investor’s chief problem to overcome.  Sure, investment returns matter over time but they don’t matter nearly as much as bad behaviour.  An impatient investor can destroy an investment portfolio.  It is my experience that successful investing is not about getting everything right, it’s about doing the right things more often than not – and that means letting your assets do all the work over time.  Furthermore, an investor is not a trader in my book.  An investor by definition has a vested interest in their holdings and sticks with them through the good times and the bad.  In fact, an investor does not chase performance but instead looks for opportunities to buy more assets at modest prices or when re-balancing is due.

“The power to tax is the power to destroy.”

-John Marshall, former Chief Justice of United States, founder of U.S. Constitutional Law

Who here enjoys paying taxes?  Anyone?  Any hands?  Just what I thought – nobody enjoys paying taxes.  Paying income taxes, property taxes and getting dinged on our value added tax (GST) at the cash register are things we cannot avoid.  However, what you might not know is Canadian investment income is taxed at favourable rates, certainly when compared to employment income.  So if you learn to put certain securities in certain accounts, you can reduce your tax burden.  For example, you might already know investment products in a registered retirement savings plan (RRSP) grows tax-deferred but securities in a tax free savings account (TFSA) grows completely tax-free.  What you might not know is Canadian dividend income is taxed favourably.  Also, high-growth, non-dividend paying stocks can be excellent investments to hold in taxable accounts since capital gains receive better tax treatment than employment income.  A good rule of thumb to remember:  any investment that is taxed at a rate lower than your employment income is a candidate to be held outside your registered accounts.  For investments that don’t fit that criteria like bonds, it’s probably best to keep them in an RRSP, registered retirement income fund (RRIF) or a tax-free savings account (TFSA).  Putting your assets in their proper location can make you a wealthier investor.

“The money you spend on money management fees is the money you never keep for yourself.”

-My Own Advisor, DIY Investor

Plain and simple, paying high money management fees are a major drag on returns.  If you don’t want to take my word for it, read this article on WhereDoesAllMyMoneyGo:

“…a 2.69% MER mutual fund consumed 92.53% of your original contribution over 25 years and left you with 49.42% less money due to the effect of fees.”

Want some more proof?  Take the Rule of 40 challenge:  take the number 40, divide it by your mutual fund’s Management Expense Ratio (MER) that you can find here and the result is the number of years it takes for money management fees to eat 1/3 of your investment.  Yes, you read that correctly.

Example:  Your high priced TD Canadian Equity mutual fund has an MER of 2.18%.  So, 40 / 2.18 means in 18 years plus a few months, about 1/3 of your investment value will be lost to fees.

Instead of worrying about investing forces of nature that are well beyond your mere mortal powers of control, forces such as stock market returns, inflation and interest rates, focus on things you can control.  My advice and my own practice seeks to keep my investing behaviour aligned with my financial plan, take advantage of the tax laws where I can and pay if I absolutely must some money management fees but not a penny more.

Any more investing enemies I should call out?  Which one above is the biggest villain to your portfolio? 

Thanks for reading and sharing this article.

“Inaction breeds doubt and fear.  Action breeds confidence and courage.  If you want to conquer fear, do not sit home and think about it.  Go out and get busy.”  – Dale Carnegie, American writer, lecturer and self-improvement guru.

Much has been written about fear.  It can be a huge deterrent or a great motivator.  Fear can confuse, frustrate and put up psychological barriers that are tough to knock down, if ever.  Fear can stop our goals from being fulfilled in any life facet.

I have a few fears.  I’m not a fan of heights for one.

My wife fears bugs, any bug actually.

What do you fear?  How does it affect you?

When it comes to personal finance, I have a few fears there as well.  I fear I’ll lose my job at some point and I won’t be able to afford the house I live in because of my fat mortgage.  I also worry that I won’t be able to save enough for retirement or retire early like I want to.

I suspect most of us have financial fears or did at one point.  Here’s what I’m doing to combat my financial fears.

Build up an emergency fund

Some time ago, I wrote about building up our emergency fund.  At this point, our fund is not quite where we want it to be but it is steadily growing.  I don’t like the idea of drawing on a line of credit (LOC) in an emergency if it can be helped.  In an emergency situation the last thing my wife and I want to do is to add-on more debt.  Having an emergency fund is a security blanket that works for us; a blanket that other folks may not need.  No matter how stable our jobs might seem, no matter how good our health may feel, $hit can always hit the fan and because of it I feel some preparations are always better than none.

Make lump sum payments the mortgage

I’ve read many times over the last few months that interest rates may not head higher until well into 2014.  Who really knows when interest rates may rise, but what I do know is this:  rates today are an excellent time to pay down our mortgage.  Yes, money is cheap to borrow but it’s also cheap to pay back.  Using Bank of Canada language with no “imminent” rate hike on the horizon, I’m working to conquer any job loss fear by getting out of debt sooner than later.  I hope to be completely debt free by 2021.

Invest using a two-pronged strategy

First up, let’s discuss the benefits of index investing (indexing).  Indexing works because I’ve learned most actively managed mutual funds underperform the index and even if fund winners are found, the winning streaks against their benchmark don’t last long.  Also, indexing works because it offers great diversification, with high transparency at a low cost.   I enjoy indexing but only do so in my RRSP.  Beyond indexing, I also use a strategy of buying and holding Canadian dividend paying stocks for income and capital appreciation.  Dividend investing takes on more risk than indexing but I feel it’s worth it because of the cash flow it generates today and with rising dividends over time it will generate more cash flow in the future.  My plan is to avoid touching any of these dividend-producing investments today because my plan is to live off most of my dividend income in retirement.

There is absolutely nothing I can do about my job but work hard at it.  There is also nothing I can do about the stock market performance to guarantee high returns.  What I can do is recognize what I fear, react (better) to those emotions and instead of dwelling on them, just get busy like Dale Carnegie says I should.

What financial fears are you busy overcoming? 

If you already conquered some financial fears, what actions did you take to achieve success?

Thanks for reading and sharing this article.