There’s no place like home

These are good times to be a Canadian equity investor. Not only have we enjoyed back-to-back banner years — the S&P/TSX Composite returned over 35% in 2009 and 17% last year— but Canadian stocks have dramatically outperformed both the US and international developed markets over the last decade.

Of course, even when Canadian stocks were lagging the rest of the world in the 1980s and 1990s, investors in this country still loaded up on them. Back then we didn’t have much choice: you weren’t allowed to have more than 20% of your RRSP in foreign holdings, and in any case, investing internationally through mutual funds was extremely expensive. Both hurdles have long since disappeared—indeed, thanks to ETFs from firms like Vanguard, investing internationally is in many ways cheaper than buying Canadian. Yet still our home bias remains.

Are companies safer because they’re more familiar?

In my recent interview with Meir Statman, author of What Investors Really Want, I asked the professor why we suffer from home bias. I suggested that perhaps we were confusing what is familiar with what is safe:

“That makes sense, because in general familiar things are safe. If a certain food was around the house when you were a kid, you got a sense from your parents that it was a good food, and that is likely to persist throughout life. If people are afraid, they stay close to home because venturing out might be dangerous. But of course, we all know you can easily overdo it and become a hermit. So what is necessary is a proper assessment of the risk of venturing out, and the risks and advantages of staying close to home. There is a need, for example, to understand the benefits of diversification, and the risk-reduction benefits that come from a global portfolio, and that might overcome the fear or hesitation to venture abroad.

“There are some other elements to it: for some it’s like a badge of loyalty. You are loyal to your own country if you invest in it: in fact you can see that in the political arena. Sometimes pension funds are required by law to invest no more than, say, 20% abroad. I know that South Africa, for example, has very severe restrictions on pension funds about how much they can invest abroad, because there is just a sense that money should be kept close to home.

“And then there is the question of what it is that my neighbours are doing, and how do I match up against them. If your neighbours are all concentrated in Canada and you venture out not just to the United States but also China and other developing markets, you might either be a big winner or a big loser relative to your neighbours, and that is something that many people find scary.”

Home bias has been observed in every country, but it’s a potentially bigger problem in small countries like Canada. The average US investor holds 70% of her equities in American stocks, but the US makes up more than 40% of the global markets, and its economy is the most diversified in the world. Canada is not only tiny (4% of the global markets), but also highly concentrated: an investor in a broad Canadian index fund has more than three-quarters of his money in financials, energy and materials.

The benefits of global diversification

Here’s a sector breakdown of the Canadian market compared with the US, international developed markets, and emerging countries. Look at how much more broadly diversified your portfolio would be if you split your equity holdings equally among them:

To be sure, there are some legitimate reasons for concentrating your investments in your own country. One is that it reduces currency risk: if your expenses are in Canadian dollars, it makes sense to hold most of your assets in the same currency. (Foreign currency can be hedged, of course, but the process is costly and not very precise.) It’s also wise to invest in Canadian stocks to take advantage of the dividend tax credit and other tax breaks. However, as Statman explains, the reasons for our home bias are mostly behavioural. It’s another obstacle we need to overcome on the road to investing success.