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.

Young People Need to Grow Both Their Financial and Human Capital

Young People Need to Grow Both Their Financial and Human Capital

By James Parkyn

Many of our clients ask us to help get their children started on building wealth using our time-tested, evidence-based approach to investing.

They know when it comes to saving and investing, the earlier you get started the better. In fact, many have told me they regret not starting much younger themselves. These parents see investing as an essential life skill and want their kids to get going as early as possible.

That’s why I wrote our new eBook, Investing Life Skills for Early Savers. I wanted to present key concepts in an easy-to-read format that’s accessible and relevant for young people. Judging by the positive response we’ve received so far, this guide has hit the sweet spot with readers.

It covers seven essential investing skills over just 28 pages. You won’t be surprised to learn the first of these is titled Getting Started. In investing, as in so many things in life, more than half the battle is taking the first step. Indeed, I’ve often thought the famous Nike slogan should have been: Just Start It.

The psychological barriers aren’t easy to overcome. But, by beginning now, you get into the habit of saving, give your money more time to compound and build your confidence to deal with market fluctuations and make smart money decisions.

Other topics covered in the eBook include the importance of cultivating an investor mindset, understanding human biases, diversifying to reduce risk and controlling your emotions.

Another skill that’s discussed is managing your human capital. It gets very little attention in the media but is of critical importance, especially for young people.

Human capital is your potential to generate income over your lifetime. It can be defined as the present value of all future income from working and, for most people, it’s their most valuable asset. For young people, it comes to a huge number and is even more valuable because it’s hedged against inflation – wages tend to rise over time.   

You can increase your human capital through education, training and cultivating interpersonal skills. You also need to protect it. You do so with such tools as disability insurance, which is less popular than life insurance, but statistically much more likely to be needed.  

If you’re like most people, you’ll be rich in human capital when you start your working life, but poor in financial capital. As you move through your career, your goal should be to convert your human capital into financial capital by earning, saving and making good investment decisions.

I encourage you to download your free copy of Investing Life Skills for Young Savers, regardless of your age. If you have any questions or comments about it, please let me know. And don’t hesitate to contact us if we can help with your family’s financial needs.

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.

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.

Why Your Investing Perspective Needs to Get Much Longer ?

Why Your Investing Perspective Needs to Get Much Longer ?

By James Parkyn

We often talk about the need for investors to take a long-term perspective and look at periods of volatility through the lens of market history.

That’s why we’ve made it a tradition to report each year on the latest edition of the Credit Suisse Global Investment Returns Yearbook. The yearbook is an invaluable resource for investors because it draws lessons from a database of asset returns from 35 countries dating back to 1900.

This year’s yearbook includes an important discussion of just what constitutes a long-term perspective. That’s especially useful after an unusual year when investors suffered negative returns in both the stock and bond markets, amid high inflation, rising interest rates and the war in Ukraine.

The yearbook notes that stocks have outperformed all other asset classes in every country since 1900. The U.S. market, for example, provided a 6.8% annualized real return between 1900-2022. But it’s been far from a smooth ride.

With last year’s decline, we’ve now lived through four bear markets in equities since 2000, including the brief but harrowing COVID crash in 2020. While these episodes have been difficult, the important thing to remember is that living with that kind of volatility is the price you pay to earn a risk premium from stocks, and to a lesser degree bonds.

But to actually bank that premium, you must remain invested and well-diversified through positive and negative periods in the markets. And those periods can be deceptively long. The yearbook offers two examples where 20 and even 40 years of market data could be deceiving.

The first is what occurred in the stock market in the 20 years leading up to 2000. During those decades, global stocks performed exceptionally well, delivering a 10.5% real annualized return. Then, the dot.com bubble burst, kicking off what’s known as the lost decade for stocks when world equities generated a negative real return of -0.6% a year.

The yearbook’s second example is from the bond market where many investors were shocked by heavy losses in 2022. They’d become accustomed to reliable gains over the last 40 years. Indeed, in the four decades to the end of 2021, the world bond index delivered an annualized real return of 6.3%, not far below the 7.4% return from world equities.

It turns out those 40 years were a historic golden age for bonds, meaning, by definition, they were exceptional. When the turning point came in 2022, it was drastic. In just one year, the real return of world bonds plummeted 27%!

“To understand risk and return in capital markets…we must examine periods much longer than 20 or even 40 years,” the yearbook says. “Since 1900, there have been several golden ages, as well as many bear markets; periods of great prosperity as well as recessions, financial crises and the Great Depression; periods of peace and episodes of war. Very long histories are required to hopefully balance out the good luck with the bad luck, so that we obtain a realistic understanding of what long-run returns can tell us about the future.”

In other words, it’s important to guard against recency bias, the tendency to give undue importance to recent events. And, when it comes to the markets, recent should be measured in terms of decades.

Investors are too often lulled into complacency by trends that are too short to make prudent asset allocation decisions. Maintaining a disciplined approach to diversification and portfolio rebalancing through thick and thin will remain the best way to combat recency bias and other mental errors that can undermine your financial plan.

For more on the Credit Suisse yearbook and a discussion of the new First Home Savings Account, download episode 52 of our Capital Topics podcast and subscribe to get more insights into the capital markets, personal finance and growing your wealth.

The Challenge of Ensuring a Secure Retirement for All

The Challenge of Ensuring a Secure Retirement for All

By James Parkyn

Government pensions have been much in the news lately and that’s not surprising given the demographic headwinds hitting retirement plans around the world.

The most dramatic events have been in France where there have been widespread, frequently violent protests against a government plan to raise the pension age to 64 from 62.

In the U.S., there’s an acrimonious debate going on among the political parties about a looming funding crisis for Social Security. The issue came into sharper focus recently with the release of a government report showing that Social Security won’t be able to make full payments to retirees starting in 2033 unless Congress does something to shore up its funding.

Meanwhile in Quebec, last month’s provincial budget introduced changes to the Quebec Pension Plan. Among the changes, the government moved up the latest age at which a QPP recipient can start receiving an enhanced pension, advancing it to 72 from 70. As well, Quebecers who are still working at 65 and older, and receiving a pension, will be able to opt out of contributing to the QPP.

The common factors in all these developments are an aging population, the retirement of the large baby-boom generation and longer life expectancies.

The OECD highlighted just how widespread pension problems are in its Pensions at a Glance 2021. It warned that “putting pension systems on a solid footing for the future will require painful policy decisions: either asking to pay more in contributions, work longer, or receive less pensions. But these decisions will also be painful because pension reforms are among the most contentious, least popular, and potentially perilous reforms.”

While demographic trends are challenging for Canada’s economy, it’s important to note that actuarial projections for both the QPP and CPP show their funding is on a solid footing for many decades into the future. (The QPP changes are mainly aimed at keeping more older Quebecers in the workforce, not shoring up its finances.)

However, the funding picture isn’t as rosy for the other principal government pension plan in Canada – Old Age Security. Unlike the other plans, OAS – and the Guaranteed Income Supplement for low-income retirees – are funded from the federal government’s general revenues, rather than a pool of accumulated savings.

As more baby boomers retire, these plans are taking an ever-larger chunk of the federal budget. OAS and GIS together already make up Ottawa’s largest spending program at nearly $60 billion in 2023-24.

Given their high cost, could OAS benefits be scaled back or the retirement age increased? It’s possible, but past attempts have proven a tough sell. Older readers will remember the famous “Goodbye, Charlie Brown” exchange between retiree Solange Denis and then prime minister Brian Mulroney that sank a 1985 attempt to limit OAS’s inflation protection.

More recently, a 2012 plan to move the OAS eligibility age up to 67 from 65 by Stephen Harper’s Conservative government, was reversed by the Liberals. Far from reducing OAS benefits, the Trudeau government increased payments in 2022 by 10% for those 75 and over.

One area where change may be in the offing is in how Registered Retirement Income Funds (RRIFs) are regulated. The Finance Department is currently studying potential changes to RRIF rules.

Several groups have advocated raising the conversion age and reducing or eliminating mandatory withdrawals as a way of ensuring that seniors’ savings last throughout their retirement years.

Currently, Canadians must convert their RRSPs into RRIFs by the end of the year they turn 71. They are then required to withdraw a rising percentage of their RRIF each year, which is taxed as income.

In a submission to the Finance Department, Laura Paglia, CEO of the Investment Industry Association of Canada, recommended raising the age at which RRSPs must be converted into RRIFs and reducing the RRIF annual withdrawal rates with the goal of abolishing them entirely.

“The existing rules date back to 1992 when interest rates were higher and seniors were not living as long,” Paglia writes. “Today, it’s unlikely real returns on safe investments will keep pace with the withdrawals. Seniors have a higher chance of outliving their savings.”

“Unnecessary RRIF payments may even trigger clawbacks in retirement income support programs such as Old Age Security (OAS), the Guaranteed Income Supplement (GIS) and provincial supplements, causing some seniors to forfeit some or all of the government benefits they might otherwise have received.”

It’s unclear how Ottawa will come down on the issue of modifying RRIF rules, given the potential impact on government finances. What is not in doubt is that pension plans and how retirement are funded will remain front and centre as the population ages and the number of retirees grows.