Legendary investor Warren Buffett, among others, is notorious for telling investors to buy what they know. Basically, Buffett and his enthusiastic followers suggest investing in companies that you really understand or at least know enough about them to be able to explain how they make money.
That is fairly good advice if you are an American since the S&P 500 generates nearly half of its revenue from outside of the United States. However, there is still a lot of risk in the form of sector concentration. For example, the tech sector accounts for nearly 21% within the S&P 500. Do you remember the bursting of the dot com bubble?
Home bias for Canadian investors is really risky. Seventy–five percent of the Toronto stock market is dominated by three sectors, energy, materials and financials. There are only a handful of companies in other sectors that are available to further diversify your portfolio. Year to date, the Toronto stock exchange is only up 5% compared to the S&P 500 which is up 18.5%, see chart below:
The Canadian market has under-performed when compared to the U.S. markets for the past five years. The main reason is the decline in oil prices which has effected many non-energy sector companies which still rely energy prices in determining their revenue growth. For instance, Canadian banks may rely on loans to energy companies to drive their growth rates. See the 5 year performance chart below:
Why home bias exists
Vanguard’s Investment Strategy Group identified a range of reasons why investors might not embrace global diversification, including concerns about currency risk and an expectation that their home country will deliver out sized returns.
One factor we identified—preference for the familiar—seems particularly relevant. With so much global uncertainty about geopolitics, monetary policy, and the economic outlook, it’s understandable why investors may not want to stray too far from home.
Why Canadian markets may continue to under perform the U.S.
- Oil and gas exports are land locked and selling at a huge discount!
- The housing market is slowing down due to a 15% foreign buyers tax, tightening mortgage rules and higher mortgage rates.
- Tariffs on softwood lumber and airplanes from our largest trading partner (U.S.) has put the success of re-negotiating NAFTA questionable.
- Passing of the U.S. tax reform legislation will make investing in Canada less attractive (plus we have a carbon tax and high electricity rates).
- Canadian consumers are carrying high levels of debt which will slow down spending.
Exchange traded funds are a low cost way to diversify your portfolio outside of North America. Many providers offer the ability to hedge fluctuations in foreign currencies.