Why too much exposure to Canadian stocks hurts your portfolio

Why too much exposure to Canadian stocks hurts your portfolio

By James Parkyn

Canada consistently ranks among the countries with the best quality of life, earning high marks for our standard of living, life expectancy, education system and environment among other dimensions of well-being.

We can be justifiably proud of the quality of life we enjoy here and it’s no doubt the reason why people from the around the world are lining up to move to Canada. However, when it comes to your investments, too much Canada is a bad thing.

A recent report from Vanguard notes that while Canadian stocks represent just 3.4% of the global equities market, Canadian investors allocate 52.2% of the equity portion of their portfolio to Canadian stocks.

This 15-to-1 mismatch is the result of the well-know phenomenon of home bias. Canada is far from the only country where investors prefer domestic holdings over foreign ones. The Vanguard report shows its even more pronounced in such countries as Australia, Japan and the Euro area.

There are several reasons why an investor might prefer to buy domestic stocks, but it usually comes down to simple familiarity. The companies that make up your local stock market, you hear about in the news daily.

While understandable, home bias is nevertheless a serious impediment to portfolio diversification, which is the key to reducing risk. This is very much the case in Canada, where a handful of companies and just three sectors dominate the equity market.

Vanguard reports that the top 10 holdings in Canada represent nearly 37% of the Canadian stock index. By contrast, the top 10 holdings make up 16% of the global stock market. When it comes to sector concentration, Canada is heavily overweighted in financial services (+16.4%), energy (+12.1%) and materials (+7.2%) as compared to the global market, and underweighted in information technology (-13.0%), health care (-11.7%) and consumer discretionary (-7.3%).

As a result, the Canadian market has historically been more volatile than the global market without a proportionate increase in return. That’s a bad deal for investors and the obvious reason why you would want to add a substantial quantity of global stocks to your portfolio mix.

Look no further than Canada’s big pension funds to see how the most sophisticated investors allocate the money they manage globally.

CPP Investments, which manages the $570-billion Canadian Pension Plan Fund, doesn’t disclose the geographical distribution of its $135-billion public equity portfolio. However, as of March 31, only 14% of its total net assets were in Canada. The Caisse de dépôt et placement du Québec, manager of the Quebec Pension Plan, had 21% of its public market equities portion of it $402 billion in net assets invested in Canada at the end of 2022.

Modern portfolio theory dictates that the broadest possible diversification will be the most efficient for reducing risk. Therefore, in theory, your portfolio would replicate the geographic weightings of the global stock market.

However, even if that were possible, we’re living in Canada and there are solid reasons for holding more than 3.4% of your stock portfolio in Canadian assets, besides a simple preference for doing so. Notably, you’re exposed to foreign exchange risk when you convert proceeds from the sale of foreign assets back into Canadian dollars.

The Vanguard paper shows that the reduction in portfolio volatility declines as the allocation to international equities increases up to 70% and then begins to taper off gradually. The paper concludes: “Looking at the data, the optimal asset allocation for Canadian investors is a 30% allocation to Canadian equities and a 70% allocation to international equities because it has been shown to minimize the long-term volatility of their portfolio.”

Our equity model portfolio devotes 20% to Canada, 50% to the U.S. market and 30% to international markets which includes emerging markets. If we remove our home bias of 20% to Canada, the remaining 80% is invested to reflect roughly the global market cap-weights.

According to our market statistics, the U.S. stock market has outperformed Canadian and international stocks in every time period stretching back for 30 years. But the outstanding performance of the U.S. market goes back much further than that.

The Credit Suisse Global Investment Returns Yearbook analyzes a database of global markets dating back to 1900. The 2022 edition (which we discussed in our Capital Topics Podcast episode 38) looks back over the international investing boom that started in the mid-1970s and asks: “Should U.S. investors have gone global?”

The Yearbook looked at four separate periods between 1974 and 2021 and found the U.S. market beat global investments in each of the four periods by a substantial margin. In other words, a U.S. equity investor, in hindsight, would have been better off foregoing international diversification and sticking with the U.S. market.

This was true not only because the returns from the U.S. market were exceptional over the period, beating non-U.S. stocks by 1.9% per year, but because it was one of the least volatile markets in the world “as its size, scope and breadth ensured that it was highly diversified.”

This historic record should give Canadian investors food for thought as they decide how best to avoid the negative effects of home bias in their portfolio. However, you should be mindful not to base your investment decisions solely on past performance.

For more insights and information on investing and personal financing topics, listen to our Capital Topics podcast on our website or wherever you get your podcasts.

We’ve also been getting very positive feedback about our new guide Investing Life Skills for Young Savers. Download your free copy and let us know if you have any questions or comments about it.

There’s No Ideal Asset Mix, but 60/40 Is Still a Good Place to Start.

There’s No Ideal Asset Mix, but 60/40 Is Still a Good Place to Start

By James Parkyn

The classic investment portfolio is a 60/40 split between stocks and bonds. In thinking about this asset mix, we consider stocks to be the risky or volatile component and bonds to be the “safe” component. Equities provide growth while the bonds provide steady income, reduced overall risk and capital preservation in that part of the portfolio.

However, those assumptions didn’t hold in 2022 – far from it. Both the stock and bond markets fell by double-digits for one of the few times in history. According to Vanguard, the typical 60/40 portfolio declined for U.S. investors by a painful 16% in 2022. And that has led some observers to question the soundness of the strategy going forward.

Those doubts turn on the evolution of interest rates that occurred during the four decades to the end of 2021. Through those years, rates as measured by the yield on a 10-year U.S. Treasury bill declined from 15.8% in 1981 to 0.5% at the end of 2021. This drop in rates supercharged capital gains on bonds. (Bond yields and prices move inversely).

The result was exceptional, low-risk returns for a 60/40 portfolio. A speaker at a recent Morningstar conference in the U.S. noted that the Barclays Aggregate U.S. Bond index returned 7.75% annually over the 40 years through 2021, generating 87% of the return you would have received just investing in stocks with 45% lower volatility. That was a pretty sweet deal.

The party ended abruptly last year when central banks, led by the U.S. Federal Reserve, began ratcheting up interest rates to slow the economy and bring down soaring inflation. Rising rates hurt both the stock and bond markets at the same time.

With the bond portion of a 60/40 portfolio no longer enjoying a tailwind from falling interest rates in an environment of high volatility and sticky inflation, some asset managers argue investors should abandon the strategy.

Leading the charge is giant asset manager BlackRock, which argued in an article that higher interest rates to fight inflation could cause stocks and bonds to continue to fall simultaneously. “In the end, bonds may lose out as well [as stocks], potentially exacerbating losses in a diversified 60/40 portfolio.”

BlackRock and other 60/40 doubters say investors should devote a greater share of their portfolio to so-called alternative investments to generate better returns. These investments include hedge funds, private assets, inflation-protected bonds, infrastructure and commodities.

Other heavyweight asset managers, including Vanguard and Goldman Sachs Asset Management, have lined up on the other side of the debate. They note that the 2022 losses have substantially improved expected returns from a 60/40 portfolio, a development I highlighted in a recent blog post.

In that piece, I discussed PWL Capital research that showed a remarkable improvement in expected returns, mostly thanks to higher bond yields. Our expected return estimate for a 60/40 portfolio went from 4.97% annually at the end of 2021 to 5.81% in the latest edition of our Financial Planning Assumptions.

Vanguard noted a similar improvement in their expected return estimates and declared: “Far from dead, the 60/40 portfolio is poised for another strong decade.”

What’s more, Goldman Sachs observed that a loss like 2022 is exceedingly rare. Indeed, U.S. stocks and bonds simultaneously lost money over a 12-month period just 2% of the time since 1926. While a big loss like in 2022 will occur, Goldman argues that 60/40 remains a valid approach.

We remain firmly on the side of those who see the 60/40 portfolio as a good starting point for the construction of a broadly diversified portfolio, especially now that formally ultra-low bond yield have normalized.

We take a skeptical view of alternative investments. They generally carry high fees and we have yet to see convincing evidence that they produce higher returns at equivalent risk levels. When you add in liquidity risk for some of the strategies, our advice is to proceed with caution. Indeed, many alternative investments suffered through a terrible year in 2022.

As I’ve discussed in earlier blog posts, longer life expectancies mean most people need the growth that comes from stocks to ensure their money lasts as long as they do. However, with bond yields returning to more normal levels, those who had previously increased their equity allocation can now consider dialling it back to reduce portfolio volatility.

Why do I say 60/40 is a good starting point? Because there’s no ideal asset mix. Your portfolio has to be customized to fit your age, life goals and risk tolerance.

In the end, the right asset allocation is the one that allows you to stay the course through inevitable market downturns. That’s the right strategy 100% of the time.

For more insights on the markets, personal finance and growing your wealth, be sure to listen to our Capital Topics podcast and subscribe to never miss an episode.

Does Diversification Still Make Sense?

By James Parkyn

It’s been a difficult year in the markets and it seems there’s been no safe harbour. With interest rates rising to combat inflation and a tense geo-political situation globally, stock and bond markets around the world have been falling.

As you know, diversification is the fundamental strategy for reducing portfolio risk. Noble Prize-winning economist Harry Markowitz famously described it as “the only free lunch in finance.” Markowitz demonstrated that broadly diversifying within and across assets classes and countries allows investors to increase expected returns while reducing risk.

However, it often seems – especially since the financial crisis of 2008-09 – that when trouble strikes, the markets tend to move down together. So, this raises the question: Does it still make sense to diversify?

To answer this question, we turned to a remarkable resource—the Credit Suisse Global Investment Returns Yearbook. It’s a guide to historical returns for all major asset classes in 35 countries, dating back in most cases to 1900.

The 2022 edition of the yearbook includes an examination by financial historians Elroy Dimson, Paul Marsh and Mike Staunton of the power of diversification across stocks, countries and asset classes. Their study of the historical data led them to several important conclusions.

• Globalization has increased the extent to which markets move together, but the potential risk reduction benefits from international diversification remain meaningful.

• The extent to which international diversification can fail investors in a crisis is limited to quite short periods and is relevant only if an investor is forced to sell. “For long-term investors, the enhanced correlations are of less consequence.”

• Over the last 50 years, investing in stocks globally has generated higher reward/risk ratios than investing only domestically in most countries.

• A notable exception has been the United States, where over the last 50 years investors would have been better off investing domestically. This finding reflects the excellent returns and lower volatility of the U.S. stock market during this period. However, the authors also note past performance is no guarantee of future returns. “We are observing these results with hindsight…There is no reason to expect American continued exceptionalism.”

• Investors in smaller markets, especially ones that are highly concentrated in certain sectors, have more to gain from global diversification than U.S. investors because “the U.S. market is already very large, broad and highly diversified.” Canadian investors take note.

• Despite well-known advice to hold a broadly diversified portfolio, the authors highlight academic studies that show most investors are woefully under-diversified. For example, they quote a study (Goetzmann and Kumar 2008) that analyzed more than 60,000 investors at a large U.S. discount brokerage house and found the average holding was just four stocks.

Investors with concentrated portfolios pay for it dearly. A Danish study (Florentsen, Nielsson, Raahauge and Rangvid 2019) analyzed a database for 4.4 million Danish investors and found they could increase their expected return by up to 3% a year by moving from the concentrated portfolio they typically held to an index fund with the same overall risk.

• On asset diversification, the authors write: “Stock-bond correlations have now been mostly negative in major world markets for some 20 years. This negative correlation means that stocks and bonds have served as a hedge for each other, enabling investors to increase stock allocations while still satisfying a portfolio risk budget.”

However, an increase in interest rates is a common variable for both stocks and bonds and this should lead to a positive correlation between them or, in other words, a more limited diversification effect. What’s more, the yearbook notes the correlation between stocks and bonds has been positive for extended periods of time since 1900. So, in the future, the correlation may be positive.

But unless the correlation is perfect, investors will still see the benefits from being diversified in stocks and bonds. And we can’t forget the important fact that bonds are less volatile than stocks.

The yearbook’s authors conclude that “there is a compelling case for global diversification, especially at the current time,” but observe the benefits of global diversification can be oversold if they are presented as a sure-fire route to a superior return-risk trade-off. Diversification should lead to a higher expected level of return for the same risk, but this is not assured.

Therefore, the best we can do is to make well-informed, prudent investment decisions and then patiently stick to our plan, especially when the markets are bleak.   

The bonds in your portfolio are doing their job

by James Parkyn

It’s been another very good year for stocks and another lacklustre one for bonds. That’s led many investors to wonder whether they should be allocating more money to stocks and less to bonds.

To the end of September, Canadian stocks were up 17.5% this year while bonds were down 4% (including interest and dividend income). Despite this performance, our advice is to proceed cautiously when considering increasing the equity weighting in your portfolio at the expense of bonds.

Yes, stocks have had strong returns since the markets bottomed out from the COVID crash in March 2020 while rock bottom interest rates have meant paltry bond yields of little more than 1%.

However, bonds do more work than just contribute to your overall returns. They play a critical role in diversifying your portfolio by acting as a shock absorber when corrections hit the stock market.

This is because bonds—especially the short-term, high-quality ones we favour—are much less volatile than stocks.

That’s important to remember at a time when equity markets have been so strong for so long. Even before the rapid recovery from the pandemic shock, stocks had a great run dating back to the rebound from the 2008-09 financial crisis. The good times have desensitized many investors to risk as we see in the surge of speculative trading in hot stocks, cryptocurrencies and special purpose acquisition companies. But risk hasn’t gone away.

We can see the shock-absorbing effect of bonds through a metric known as the Sharpe ratio. Named for its inventor, Nobel laureate William Sharpe, it measures the performance of an investment compared to a risk-free asset, after adjusting for risk. When comparing two portfolios, the one with a higher Sharpe ratio provides a better return for the same amount of risk.

As economist and market strategist David Rosenberg demonstrates in this article the addition of a meaningful portion of bonds to a portfolio dramatically improves risk-adjusted returns.

Rosenberg calculates that an all-stock portfolio over the last five years had a Sharpe ratio of 1.08 compared to 1.2 for a portfolio composed of 60% equities and 40% bonds and 1.25 for a 50/50 mix. So, despite the low returns of bonds over the last five years, the Sharpe ratio increases because the bonds substantially reduce the volatility of the portfolio. The same pattern can be seen over 10-, 20- and 30-year periods.

Besides being a buffer against volatility in the stock market, there’s another reason why bonds are useful in a portfolio. When the stock market suffers losses, you can use your bond allocation to raise cash to cover your spending needs, while you wait for equities to recover. You can also use it to buy stocks when they are down.

Of course, a 100% stock portfolio will have higher expected returns, but it is also riskier. Good portfolio management involves finding the right balance between risk and reward given your goals and tolerance for risk.

The bottom line is we believe a bond allocation should viewed as a portfolio stabilizer, not an impediment to maximizing your returns. Experience has taught us that a lower volatility portfolio is going to produce better, more tax efficient performance over the long run than a highly volatile one.

So, don’t worry about your bonds, they’re doing their job.

4 essential investing lessons from the last two decades

by James Parkyn

At PWL Capital, we believe it’s crucial to take a long-term view of investing. That’s why I sat down recently with my colleagues François Doyon La Rochelle and Raymond Kerzérho to talk about our investing lessons since 2000 for an upcoming episode of our Capital Topics podcast.

The common denominator in our discussion was the importance of patience for successfully building your wealth over the long term.

You only have to consider the many momentous events that have occurred during the last two decades to understand why patience is so important. The list includes the bursting of the tech bubble in 2000, 9/11, the Afghanistan and Iraq wars, an extended bear market in 2001-03, the financial crisis of 2007-09 and, most recently, the COVID-19 pandemic.

Through it all, the stock market has kept going up. Since September 2001, the S&P 500 has gained an annualized 8.2% per year in Canadian dollars, while the S&P/TSX Composite in Canada is up an annualized 8.1%, and the combined MSCI EAFE and Emerging Markets index is up 6.6%.

If you had let your emotions get the better of you and bailed out of the markets in response to any of the events listed above (or the many others of lesser importance), you would have deprived yourself of those gains.

With that in mind, here are the four most important lessons to take away since 2000.

1. You don’t know what you don’t know

This phrase encapsulates the deceptively simple observation that no one knows what the future holds or what impact events will have on the markets. For example, no one could have predicted the terrorist attacks of September 11, 2001, or the devastation of the global pandemic.

Howard Marks, co-chairman of Oaktree Capital Management, summed up the importance of intellectual humility when investing this way: “No amount of sophistication is going to allay the fact that all of your knowledge is about the past and all your decisions are about the future.”

2. You can’t forecast the future, but neither can anyone else

This lesson is a corollary to the last. Despite the impossibility of predicting the future, many economists, analysts and active investment managers earn their money trying to do just that.

All the noise they create can lead you astray from your investment plan with dire consequences for your wealth.

3. Investor behaviour and discipline are crucial

To avoid pitfalls, it’s essential to develop a disciplined investing mindset. This means filtering out the noise of the moment and sticking resolutely to a long-term view that’s guided by your investment plan.

A well-designed investment plan is a roadmap you can return to when times are tough and you are tempted to stray off-course. Your portfolio should be aligned with your risk tolerance and risk capacity. It should also be tax efficient and broadly diversified. These are the factors you can control.

4. Evidence-based investing works

I recall in 2003 when as a firm we made the decision to implement fully passive portfolios. My experience in the years that followed has confirmed my belief that adhering to scientifically verified principles of sound investing is the best way for our clients to have a successful investing experience.

It has produced solid investment results for them and remarkable growth for PWL Capital as more and more people have embraced the power of low-cost passive investing and the other best practices we follow. It’s an approach to investing that gives clients the confidence to stick with their investment plan through good times and bad.

Be sure to download our podcast to hear more investment lessons from the past two decades. You can also learn more about the fundamentals of evidence-based investing by downloading your free copy of our eBook, 7 Deadly Sins of Investing.