If you’ve followed Garth Turner even obliquely as I have over the years, you know that the financial advice that Mr. Turner dispenses in his columns, TV shows and his blog can often be, shall we say, a bit questionable. After all, this is the same guy who recommended buying Nortel at $40 as it was falling off a cliff. But, hey, everyone thought Nortel was going to rule to the world, so it may be a bit unfair to single out Mr. Turner for recommending it to readers.
Fast forward to 2011 and Mr. Turner has made a recent career out of forecasting an impending implosion in the Canadian housing market. He’s been at it for the past three years and for a short while in late 2008, it did seem that his prediction was coming true. Except that after a brief downturn, the housing market recovered all its losses and marched even higher. The markets can be merciless on prognosticators.
The housing market could still crash and Mr. Turner could very well turn out to be right. But I’m pretty sure that some of the financial advice that Mr. Turner dispenses on his wildly successful blog to take advantage of a real estate crash is extremely suspect. Take this recent post as an example. In it, Mr. Turner recommends that Al, a 45-year old Oakville resident with a wife and two kids living in a $425,000 paid-off home, should take out a $200,000 loan secured by the property and invest it in a balanced portfolio (40% fixed income, 60% stocks). Mr. Turner estimates that Al will be borrowing at 3% and “making 8% or so”, which implies spending $300 per month on interest on the loan and earning $1,000 in the form of “capital gains and dividends”. Mr. Turner says:
This is called diversification. It mitigates against having the bulk of your net worth in one asset alone. It lets the government pay for a big chunk of your borrowing. It takes non-performing real estate equity and turns it into income-producing capital. It takes advantage of generationally-low interest rates to create your own carry trade. It builds up the critically-important non-registered side of your investment portfolio, since RRSPs are destined to become tax bombs.
This advice is so bad that I don’t even know where to begin. First, an 8% expected return from a balanced portfolio is not very likely at a time bonds are yielding 3%. Second, it doesn’t make much sense for anyone to borrow short at 3% and lend long at 3%. Third, holding bonds in taxable accounts is terrible when Al also has $200,000 is his RRSP account. Fourth, home equity is not “non-performing” when the owner is living in it (and not paying for the privilege). Fifth, borrowing against a free-and-clear property is not “diversification”; it is leverage.
Last but not least, Al will be in big trouble should housing markets crash, a drum that Mr. Turner is fond of beating relentlessly. His home value will drop, his leveraged portfolio will likely take a large hit and with a shaky economy, he may also be facing a bleak job situation. Meanwhile, he is still servicing the loan and income from the portfolio may not cover his interest expenses entirely. As if Al isn’t in enough trouble already, if we are facing the financial Armageddon that Mr. Turner has been predicting, Al’s bank may be in trouble and may want that loan back. Al’s situation could turn out to be similar to that of an investor with a large position in Nortel who borrowed against his holdings and invested the proceeds in US stocks back in the early 2000s. Today, the Nortel holdings are worth zero, the US stock holdings have lost money and the investor would have been paying interest on his loan for 10 years with only losses to show for it.
Updates: Garth Turner responds by saying that “8% return is no stretch” when his portfolio made 15% last year. It’s hard to argue with such sound logic.
Nick Rowe of the Worthwhile Canadian Initiative blog explains why Garth’s suggestion is not diversification. Check out this comment in the post for the heavy duty math on why leveraging doesn’t reduce risk (as measured by variance).