Archive for January, 2007

Reader Question: How will the S&P 500 Perform in 2007?

January 30, 2007


I am introducing a new weekly feature to answer reader questions publicly. It helps me to publish a meaningful post and you get the extra benefit of feedback from other knowledgeable readers. You are welcome to contact me via email at ccapitalist(at)yahoo(dot)ca with “Reader Question” in the subject line and I will try my best to answer it, failing which I will ask other readers for help.

To kick off the new feature, here’s a question from Marc:

I am planning on investing in the iShares S&P 500 ETF (XSP on the TSX) and I am wondering if you think the S&P 500 will continue to perform well in 2007.

I’ll assume that you have devised an asset allocation that is suitable for you and want to invest in the S&P 500 index for the US equity portion of your portfolio.

The S&P 500 has staged a significant recovery from the depths of the previous bear market. After posting negative returns in three calendar years, the index has returned 28.7% in 2003, 10.9% in 2004, 4.9% in 2005 and 15.8% in 2006. Will the S&P 500 continue its positive streak this year?

I am a firm believer that you cannot predict stock market returns, especially over such a short time frame. You will find market pundits publish “target” values for the S&P 500, but such forecasts have a sad history of failing to materialize. It is far more useful to compare the S&P 500 (trailing) earnings yield of 6.25% to the benchmark 10-year US Treasury yield of 4.87% and conclude that it is probably a good time to invest in US equities. If you are still interested, you can find analyst forecasts for S&P 500 here.

Also, note that the XSP ETF is currency neutral and you’ll get the S&P 500 returns in C$ less expenses. If you want the unhedged version, you may want to consider directly investing in IVV.

Book Review: Spend Smarter, Save Bigger

January 30, 2007

[Front Cover of Spend Smarter Save Bigger]

Margot Bai, the author of this new book kindly agreed to send me a copy for review. The idea behind the book is to show people how to save money by spending smartly on their biggest expenses like a home or a car, unlike other popular books that suggest that you should cut out small expenses like a daily latte.

Ms. Bai covers an astonishing range of topics in her book ranging from safe driving habits (reduces chances of collisions and results in lower automobile insurance premiums) to relationship advice (divorce has a devastating effect on finances too) to tips on getting lower premiums on life insurance (I wish I had known this when we obtained our life insurance). The book is targeted at a Canadian audience and its 297 pages are packed with practical advice.

The author gets extra points for offering, in my opinion, excellent investing advice. She discusses couch potato portfolios, stresses the importance of reducing costs and talks about low-fee mutual fund options. For example, to folks who are not comfortable investing on their own and would like a bit of handholding, Ms. Bai offers this advice:

By investing directly with a particular fund company, you can invest in a great mix of low fee funds that pay no commission and gain access to free, unlimited, expert advice on managing your investments!

The book is well-written, easy-to-read, provides sound financial advice and deserves a spot on the best-seller list. I recommend it highly and I am replacing The Automatic Millionaire with this book in my Recommended Reading Page. You can purchase the book for $20 plus shipping and handling from the Spend Smarter website or at a discount from (non-affiliate link). The table of contents and a chapter summary are available here.

The Smith Manoeuvre Debate

January 28, 2007


About one year back, I did a review of The Smith Manoeuvre (SM) book and noted that the book should have talked about the pitfalls involved with the strategy. Many financial planners have left comments disagreeing with my review (though I reviewed the book, not the strategy) and I challenged one planner to show me how a client implementing the SM will come out ahead in the worst-case scenario (this particular planner uses segregated funds, so he tells me the worst case scenario is 0% returns).

The planner’s client (let’s call him Joe) owns a house appraised at $350K and has a $260K mortgage on it. His monthly mortgage payment is $1,520. To implement the SM, the planner takes out a secured investment loan of $55K and invests the proceeds (less expenses) in segregated funds. To service the investment loan, Joe pays an interest of $275 per month.

To make an apples-to-apples comparison, I am going to assume that Joe can make an extra payment of $275 towards his mortgage principal. If Joe can find an extra $275 savings for the SM, he can find a similar amount for a mortgage pre-payment.

After five years, let’s assume that Joe’s home is still worth $350K (the home’s value doesn’t affect the outcome). If he had opted for an accelerated mortgage pay down, he would have a mortgage balance of $211K and he has a net worth of $139K. If Joe had implemented the SM instead, after five years, he would own the $350K home, an investment portfolio of $99K and a loan of $321K, leaving him with a net worth of $128K.

What about after 10 years? With mortgage pre-payments, Joe’s net worth would be (Home:$350K – Mortgage:$149K) $201K. The SM would leave him with (Home:$350K + Investments: $160K – Loan:$321K) $189K. Even after 15 years, Joe would be better off with a mortgage pre-payment (net worth of $280K) than the SM (net worth of $270K).

Now, surely over 20 years Joe would have come out ahead, right? Not really. With pre-payment Joe now owns his home free and clear. The SM also results in a mortgage-free home, but Joe now has a portfolio of $346K and an investment loan of $321K and a net worth of $375K. But, the key difference is that Joe hasn’t made a mortgage payment for 17 months, which if he had saved would have added an extra $31K to his net worth.

The point of this exercise is not to show that the SM doesn’t work but that it entails taking a small risk, not any risk at all as many planners claim. You should also note that this particular SM example involves a higher leverage and would become risky if a severe real estate downturn should occur. Also, while segregated funds may give you peace of mind, it also comes with a higher price tag. If you are earning 8% in the markets and giving up 3% in expenses, you would probably just break even with the SM. I’ll close with a comment made by David Trahair, author of Smoke and Mirrors, in a recent Toronto Star column: “It’s a high-risk strategy because you’re betting the farm that some investment adviser can do better than you can. You have a guaranteed return from getting rid of the mortgage.”