Maligned as the Canadian stock market is these days, investors own too much of it.
Investing giant Vanguard found in a recent study that just more than 50 per cent of the stock market exposure in Canadian investor portfolios is allocated domestically. That’s down from 67 per cent in 2012, a significant improvement. But Vanguard thinks Canadians are still putting their portfolios at risk through their home bias.
If you live, work and plan to retire in this country, investing in Canadian stocks is the right thing to do. But it’s never been harder to decide on the right mix of domestic, U.S. and international stocks. The U.S. market seems invincible, and stock markets outside North America have also delivered. Oh, Canada. How much of your underperformance should investors tolerate?
Vanguard says that overweighting Canada can add volatility, or sharp ups and downs. Another issue is the lumps sector mix in Canada. Four sectors – financials, energy, industrials and materials – account for about 75 per cent of the market. Aside from tech at a puny 8 per cent, each of the other six sectors of the S&P/TSX Composite Index has a weighting under 4.5 per cent.
The cure for home bias is global diversification, but it brings us to a weightier risk. It’s overemphasis on the U.S. market, which has been nothing less than stunning in the past five years. The S&P 500 has an average annual total return for the five years to May 31 of close to 16 per cent, and the 12-month gain is around 28 per cent.
If you take the long view of investing, returns from the stock market should average in high single digits. When you get five years of returns at close to double that rate, you have to wonder when a correction is coming and how rough it will be.
It could be a weaker economy that triggers a pullback, a geopolitical event or a shift in sentiment away from the tech stocks that have led the U.S. market. What we do know is that U.S. stocks will not deliver strong double-digit returns indefinitely.
Back in the 1990s, a more speculative tech boom produced a series of massive returns for the S&P 500. The subsequent reckoning included three straight declines from 2000 through 2002, which delivered a drop of about 22 per cent.
The S&P/TSX Composite’s five-year annualized total return is 10.1 per cent, with a 12-month gain of 17.6 per cent. But both the three- and 10-year averages are in the area of 7.5 per cent, which is pretty much what you should expect on an average annual basis through a lifetime of investing.
Still, it’s fashionable to be down on the Canadian economy and stock market right now, and not just because of comparisons to markets in the United States and elsewhere in the world. Questions are being raised about our weak economic productivity compared with the United States and the lack of action from government and businesses to address this issue. In a future column, I’ll look at what Canada’s productivity problems mean to your personal finances.
Doubts about Canada as a place to invest are reflected in the flow of money into exchange-traded funds. Almost eight times more money went into U.S. equity funds than Canadian equity funds in the first five months of the year.
Global ETFs have also been more popular than domestic funds this year. The Morgan Stanley Europe Australasia Far East Index, or EAFE, has a five-year annualized total return of 8.1 per cent and a 12-month gain of 18.5 per cent.
Vanguard says Canada accounts for about 2.7 per cent of stocks globally, but a realistic default mix for your stocks could be one-third Canada, one-third U.S. and one-third outside North America. Another thought on diversification in mid-2024: Consider bonds.
Bonds have been a horrible investment in the past five years, and some investors have less exposure to them now than they used to. But the future seems brighter for bonds if interest rates decline as expected and inflation eventually weakens. Any economic setbacks that hurt stocks would actually help bonds by pushing rates lower.
As for your stocks, mind all your biases. Too much U.S. content could hurt you more in the near future than too much Canada.
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Rob Carrick