Geographic diversification is key to protecting your investment portfolio. Any country’s stock market can experience long periods of underperformance.
If you had invested $10,000 US dollars in Japan’s stock market on March 12, 1996, how much would that be worth on March 19, 2020?
But that couldn’t happen in Canada
Fortunately, Canadians don’t invest very much in Japan. In fact, of the stocks that Canadians hold in their portfolios, close to 60% are Canadian. This is incredible considering that the Canadian stock market only accounts for about 3% of global stock markets.
So, why do Canadians invest so much of their retirement savings in such a small stock market? Because we know Canada; investing in it must be safe! Nothing like what the Japanese stock market experienced could happen in Canada. Right?
Look at the total returns of the Canadian stock market (blue line) in the chart below. Between June 28, 2008 to April 28, 2020, the total return for the Canadian stock market was -7.9%. The total return for the world stock market (green line) was 83%.
This doesn’t mean that Canada is a bad place to invest. Any country’s stock market can experience long periods of underperformance. Look at the table below, from The Rate of Return on Everything, 1870-2015:
The real (after subtracting inflation) annual rate of return on equities (stocks) for all countries shown was 7% for the entire period, 8% since 1950 and 9% since 1980. For any period, some countries have outperformed the average and others have underperformed. This isn’t something that you can predict going forward and you shouldn’t try. You should get exposure to every country.
Look at the geographic breakdown of Vanguard Canada’s All-Equity ETF (VEQT):
- 30% Canada
- 41% US
- 29% Rest of the World
The 30% allocation to Canada is half that of the average Canadian portfolio, which means that VEQT would be much better protected in the event that the Canadian stock market continues to underperform.
When home bias can be good
You might have noticed that 30% is still much higher than Canada’s 3% share of global equity markets. This is because our expenses are generally in Canadian dollars and keeping a sizeable portion of your portfolio in the Canadian stock market helps protect against the risk that currency fluctuations could hurt your spending power.
Similarly, Canadians should allocate most or all of their bond allocation to Canada. It helps protect against currency risk and the real rates of return on bonds are so low that the differences between countries matter less:
Vanguard Canada’s Balanced ETF (VBAL) does this with its bonds, where 60% are Canadian and the other 40% are hedged to the Canadian dollar.
Don’t bet your retirement savings on the Canadian stock market. It’s only 3% of global equity markets, and it could underperform the rest of the world. Instead, protect your portfolio by diversifying globally.