Canadians exhibit far too much home bias with their investments – while some home bias is normal and maybe useful if it helps reduce psychological barriers to investing at all, it can be particularly dangerous in Canada not only because of economic and stock market industry concentration but also the high proportion of total market capitalization represented by relatively few very large companies. This is a danger for investors that hold the entire Canadian index, to speak nothing of the portfolios we’ve seen that contain concentrated positions in a few Canadian stocks. Home bias has really hurt Canadians recently but it’s never too late to diversify!
One of the cornerstones of a sensible, evidence-based investment strategy is diversification. Dimensional Fund Advisors (www.dimensional.com), who manage some of the best funds for investors who want to take a sensible, evidence based approach (full disclosure: at Chalten we use Dimensional Funds in some of our client portfolios) talk about 4 principal benefits of diversification:
I.Diversification Helps You Capture What Global Markets Offer
II.Diversification Reduces Risks That Have No Expected Return
III.Diversification Smooths Out Some of the Bumps
IV.Diversification Helps Take the Guesswork out of Investing
Now of course they also point out that diversification means you may miss out on some fantastic opportunities arising from more concentrated bets on individual stocks or by making market timing bets. However this is extremely difficult (easy with hindsight, right!) For example, between 1994 and 2014 all stocks globally earned a compound annual return of 7.5%. If you missed the top 10% of performers each year your annual return would drop to 3.2%. If you missed the top 25% of performers each year your annual return would drop to -6%! (thanks again Dimensional for the data) It doesn’t pay to try to win because the cost of loss in terms of fees and risk isn’t worth it. 7.5% market return is great, embrace it with diversification!
This is a message we’re really trying to drive home to Canadians. The Canadian market has underperformed recently mainly due to the weakening of the Canadian dollar and poor returns in certain sectors. Of course now we are getting questions about whether perhaps it’s too late to try to diversify, or whether at this point one should stick around for the rebound and therefore stay concentrated in Canada. The evidence suggests that kind of effort to chase market returns is a sucker’s game. Diversify now and look forward to a better long term investment experience.