Just how Canadian should your portfolio be?

When it comes to choosing investments, we Canadians are a patriotic lot. Some 70% of the equities we hold are in the domestic markets, even though Canada makes up less than 4% of the world’s capital markets. We’re not alone, of course. Americans are more apt to invest in America, and the Japanese in Japan. Around the world, people tend to put their money into domestic investments because they’re more familiar with them.

This so-called “home country bias” starts from the moment most of us begin to invest. When I bought my first mutual fund more than 15 years ago, I naturally gravitated toward a fund that was as Canadian as a Guess Who album. Homegrown stocks seemed safer—I just wasn’t ready for the exotic allure of Brazilian oil stocks or Indian carmakers.

But now, with the Canadian dollar so strong, I’ve noticed that more investors are interested in loading up on American stocks. Which raises the question: Just how much of your portfolio should be in foreign equities anyway?

It turns out, there’s no easy answer. We spoke to two financial experts, and each gave surprisingly different advice. So I’ve decided to let them fight it out, and I’ll call the winner after we’ve heard their arguments.

In one corner of the ring, we have David Baskin, president of Baskin Financial Services in Toronto. He says he typically puts a whopping 85% of his clients’ equity money into Canadian companies. He knows he’s putting all his eggs into one geographical basket, but insists there are three good reasons to invest almost all of your money at home.

The first is foreign exchange risk. Baskin says investors who plan to spend their retirement income in Canadian dollars should hold their assets in the same currency. “Otherwise you open yourself up to the tragedy that befell so many Canadians when our dollar took off.” In 2009, while U.S. stocks made huge gains, the plunging American dollar trimmed some 15% from the returns of Canadians holding those stocks.

The second is the better tax treatment you get with Canadian companies. If you’re investing outside a registered account, dividends from Canadian stocks are eligible for a significant tax credit. On an income portfolio yielding 4.5%, Baskin says the higher taxes on U.S. dividends can knock about 1.25% off your returns. “That might not sound like much, but 1.25% per year, compounded, is huge.”

Baskin’s last reason is geopolitical risk. Markets in Western Europe and Japan are no riskier than those in North America, but emerging markets are a different matter. Dubious regimes in countries such as Venezuela—which has expropriated foreign assets in the past—could put your capital in peril.

In the opposite corner of the ring is Brad Steiman, a director at Dimensional Fund Advisors in Vancouver. He says that hav­ing a properly diversified account trumps Baskin’s concerns, and by overweighting Canada, you are inadvertently overweighting certain industries. That’s because almost 80% of the S&P/TSX Composite Index is made up of just three sectors: financials, energy and materials. By investing only in the TSX, you have very little exposure to technology, consumer staples and health care. The U.S. market is more diversified, with seven economic sectors each comprising 10% to 20% of the S&P 500 index.

That’s one of the reasons why Steiman says Canadians may want to put just 20% to 40% of their equity holdings in domestic stocks, and the rest in foreign equities. “Your currency allocation and your asset allocation should be separate decisions,” he says, adding that hedging can help with currency risk.

So who’s right? Both sides of this debate make good points. The average Canadian’s portfolio is subject to a strong home bias that’s not always rational. But you can’t blame people for sticking close to home. It’s easier to put your money into companies you know, plus currency risk and the dividend tax credit are real factors.

To solve the dilemma, I suggest a compromise. If you’re an index investor using ETFs, I recommend going for true global diversification in the equity portion of your portfolio with 1/3 Canadian, 1/3 U.S. and 1/3 international stocks, the allocation for our Global Couch Potato portfolio. With ETFs, there’s no need to monitor individual stocks. Plus, currency hedging is often already built in.

If you pick your own stocks, however, we suggest something close to 50% domestic equities and 50% foreign. That’s because currency hedging is impractical for you, and it’s more important that you know the companies you invest in. Dividend investors should go even heavier on homegrown stocks, so you don’t miss out on the dividend tax credit for Canadian companies.

By the way, a good way to get some diversification if you’re a stock picker is to focus on international companies based in the U.S. Global giants such as Wal-Mart, Coke and IBM are easy to research, and they offer international diversification, as they are exposed to economies all over the world.

After all, it’s good to wave the flag. But when it comes to your investment portfolio, waving a few flags turns out to be the smartest strategy of all.