At the mid-year mark, the Canadian large cap benchmark TSX is essentially flat year to date. Given Canadians knack for keeping their investments close to home I wouldn’t be surprised if many domestic investors returns are just as flat.
That’s a problem. The best pension plans in the country wouldn’t dream of being so patriotic. If anything, they’d likely see it as borderline reckless. Why? Canada represents only a little over 3% of the world’s stock market capitalization, yet for some reason we feel content to invest in this small pool and ignore the rest of the world.
Shop the world
Think of it this way: let’s say there is a sale on at your favourite store. For argument sake, let’s say each aisle had many of the same sorts of goods, but in different quantities. Some may have more electronics while others may have more lumber, and so on. But despite knowing there are sales throughout the store, you continue to shop in a single aisle, knowingly overpaying for items that might be on sale in the next row. That’s essentially what investors are doing.
Investing internationally has repeatedly shown it can increase overall returns and lower overall risk. The return differential is startling alone. Looking at my Morningstar/Andex chart, I see that American large company stocks (as measured by the S&P 500) have outperformed the S&P/TSX by 1.6% annualized over the past two-thirds of a century. Now imagine if you could increase your overall return by up to 1.6% annually without taking on any more risk. Other parts of the world tell a similar story.
Why diversification works
One of the great things about diversification is that different asset classes are weakly (and occasionally even negatively) correlated. Sometimes, one asset class will be down when the other is up. The important takeaway here is it won’t be the same one that’s down or the same one that’s up. In short, diversifying can do wonders for your lifetime wealth accumulation. It can lower risk and enhance returns simultaneously.
I can’t begin to tell you how many people come to me with significant portfolios that are essentially fully invested in Canada. The problem is known as home country bias or simply home bias. It’s not unique to Canada, although that offers little comfort. Investing more outside of their more familiar home borders can help virtually just about every investor.
Research done over 25 years ago by a team of academics led by Gary Brinson showed that over 90% of the variance (i.e. risk) in a portfolio can be explained by an investor’s investment policy. The questions here are: what are the asset classes to invest in and what are the normal, target weightings for each of those asset classes?
Time to break bad habits
In stark contrast, most people I know (including many high-flying advisors) still act as though investing is about market timing and security selection. It isn’t. It never was. In fact, the Brinson research showed that the cumulative impact of those considerations was extremely modest—and sometimes negative.
The problem seems to be that old habits die-hard. A generation of advisors and investors was brought up on the unfounded premise that investing is about security selection and market timing. Sadly, there are still many investors who are stuck in the past. Building portfolios primarily out of domestic positions is like conducting business using rotary phones. You can do it, but anyone who sees you in action will conclude that you haven’t been keeping up with the times.
John De Goey is a portfolio manager with Industrial Alliance Securities Inc. (IAS) and the author of The Professional Financial Advisor IV. The views expressed are not necessarily shared by IAS. Industrial Alliance Securities Inc. is a member of the Canadian Investor Protection Fund.