With the recent fluctuations in the market, the level of anxiety among Canadian investors has inched upwards. Markets worldwide have been volatile in December and January, but the Canadian market has been more seriously shaken, with particular damage coming from energy and material stocks. This discomfort is easy to understand: most Canadians have a massive home bias (overweight position in the local market). While there are reasons to hold more Canadian stocks in a portfolio, they hardly out-weight the extra risk.
Home Bias Pros
First, Canadian stocks benefit from the Canadian Dividend tax Credit, while foreign stock dividends do not. This factor is not irrelevant. Stocks tend to yield roughly 2% and 3% (let’s settle for a rough average of 2.50%), and the income tax advantage of Canadian Dividends over Foreign dividends sum up to about 12 percentage points for high tax bracket investors. So a quick back of the envelope calculation leads us to believe that Canadian stocks generate [12% X 2.50%] = 0.30% more return in taxable portfolios (not in RRSPs and TSFAs). Not a bad start!
Second, Canadian stocks, in contrast with foreign stocks, are not affected by foreign withholding taxes (FWTs). In some situations, FWTs are often recoverable (depending on the type of account where the investments are located), but also sometimes not. This is a rather complex topic that is really well handled by our colleague Justin Bender in this paper. Depending on the type of account (taxable, RPS, RIF, TSFA) and the choice of investment vehicles, the cost of FWT will likely range between 0% (in many cases it is fully recoverable) and 0.50%.
Lastly, a well-known feature of the Canadian market is its heavy weight in resource stocks (currently 31%). Resources usually do well in inflationary environments. Therefore, a heavy tilt towards Canadian stocks helps the portfolio perform well during times of rising inflation, which is often very challenging for other equity sectors.
Home Bias Cons
From a risk management perspective, home bias is a disaster. Almost 70% of the Canadian market is concentrated in three sectors: financials, energy and materials (mining stocks). Even worse, some sectors are almost unrepresented in the Canadian market, most notably healthcare (3.5% of the Canadian market; Valeant Pharmaceuticals alone represents 2.9% of that!) and technology (2.2%). Canada’s ten largest stocks make up 36% of the market. It’s no wonder that home-biased investors have the jitters!
Secondly, Canada represents only 4% of global markets. By concentrating here, home-biased investors greatly narrow their opportunity set. A globally-diversified portfolio will be a lot better balanced across sectors. Furthermore, no individual stock collapse – not even the largest companies – will weigh enough to damage a globally-diversified portfolio.
Last but not least, a global portfolio will bring you behavioral benefits and peace of mind. When you hear your family and friends recount the ups and downs of their individual stocks at cocktail parties, you’ll have peace of mind knowing your portfolio is stable. This allows you to step back from the noisy daily headlines and make better decisions for the long run.