Has Canada’s luck run out?

For all the talk about our country’s strong banks and coveted natural resources, investors might be surprised to learn that Canada has lately had one of the worst-performing stock markets. At press time, the S&P/TSX Composite Index had fallen 13% over the last 12 months, while U.S. stocks had gained 4%. So far in 2012, even Europe is kicking sand in our faces.

This isn’t just a short-term trend. Canada’s glory days were back in the mid-2000s: we’ve lagged the global markets over the last three years, and the U.S. has outperformed Canada over the last five. Are our best days behind us?

If so, investors don’t seem to care: most Canadians dramatically overweight domestic stocks, even though our market is tiny (5% of the MSCI World Index) and poorly diversified. Some Canadians even insist on 100% homegrown portfolios. “I’ve had clients ask, ‘Why should I invest anyplace else when my best investments have been Canadian?’” says Tony De Thomasis, a portfolio manager with De Thomas Financial in Thornhill, Ont.

One of the reasons our stock returns have been sluggish is that Canada is now perceived as lower risk compared with the rest of the world. “Admired economies typically don’t produce great returns,” says Art Johnson, portfolio manager at Scotia McLeod in Calgary. We’re even seeing this in the bond market, he says. “I can get much higher yields outside of Canada for literally the same risk, because we’re so admired.”

Indeed, the best years for Canadian stocks followed a period when we looked like a banana republic: in the mid-1990s our credit rating was cut and we wrestled with a huge deficit.

No country’s outperformance lasts forever, so the best strategy is diversification. Since 1970, the average returns of Canadian, U.S. and international stocks have been remarkably similar, but they have varied dramatically over shorter periods. That’s why holding a globally diversified equity portfolio—say, one third in each region—lowers volatility without sacrificing returns. Many Canadians ignored that advice when we were on top of the world. Maybe now it will sink in.