You’re probably aware that the U.S. stock market has generated exceptional returns over the last decade. You may not know just how good those returns have been compared to the Canadian market.
PWL market statistics show the annual return of the U.S. market was almost triple that of the Canadian market over the 10 years to the end of 2020—16.7% versus 5.8%.
However, most Canadian investors will have missed out on reaping their fair share of those U.S. returns because their portfolios are so heavily tilted toward Canadian stocks.
In fact, a 2014 Vanguard study found that Canadian stocks made up 60% of the equity holdings of Canadian investors, on average. Of course, that was far above Canada’s 4% weight in the global equity markets at the time.
The preference Canadians have for domestic stocks reflects what’s known as home bias—a phenomenon seen around the world.
As you probably know, adding international stocks provides valuable diversification to your portfolio and reduces volatility, but what are the optimal weightings between Canadian, U.S. and international markets? Before we tackle that question, let’s look at why Canadians prefer to invest in their home stock market.
Another Vanguard paper suggests one important reason is simple inertia. A heavy weighting in local stocks may have built up over the course of many years of investment decisions. To the extent the overweighting is conscious, Vanguard says it usually reflects optimistic expectations about future returns from the home market.
Another obvious reason is familiarity. We interact with many of the largest companies in the Canadian stock market, including the banks, insurance and telecom companies, and have good knowledge of others, like the railways and energy companies. This leads to a level of comfort in investing in our home market.
After that, there’s a series of other considerations that go into the home bias. These include concerns about the volatility of foreign markets and currency, as well as tax and cost issues. For example, Canadians might prefer to invest in domestic companies because they benefit from the dividend tax credit.
However, we know the Canadian market is dominated by a relatively small number of large companies and is heavy in financial, energy and resource stocks. Adding foreign equities gives you exposure to a far larger number of stocks and better sector diversification, making your portfolio less risky and less volatile.
Still, there are good reasons to own a higher percentage of your equity portfolio in Canadian stocks than the 3% they currently represent in global markets. Most fundamentally, we live in Canada and spend Canadian dollars, therefore we don’t want too much exposure to foreign currency risk.
(Some exposure to foreign currency is a good diversifier. For example, U.S. stocks can buffer a meltdown in world markets because turbulence usually provokes a flight to the U.S. dollar. But too much foreign currency exposure creates undue risk.)
As my colleague Justin Bender discusses in this article, a higher exposure in Canadian stocks than their global weighting actually reduces risk for the same level of return, among other advantages.
The evidence indicates we should aim for a “not too hot, not too cold” approach to Canadian equities. We want the right percentage to enjoy the diversification effects that provide a minimum volatility profile for a given level of desired return. That’s why we target the following weightings in our equity portfolios: 20% Canadian, 40% U.S and 40% International/Emerging Markets.