Why solving home bias in investing is more complicated than it sounds

Why solving home bias in investing is more complicated than it sounds

Andrew Feindel: Diversification may have its benefits, but capitalizing on those benefits isn’t as simple as diversifying for its own sake

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By Andrew Feindel

Peruse the financial news and you will encounter headlines about the downsides of home bias and the advantages of geographical diversification. However, catchy headlines and adages obscure the underlying complexities of solving home bias. The reality goes far beyond having a certain percentage of your portfolio in foreign investments and is subject to many contributing factors.

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Market valuations, positioning for impending economic cycles, taxes, transaction costs, liquidity, currency risks and personal circumstances — age, cash flow needs and financial goals — are all important considerations when building an investment strategy. Diversification may have its benefits, but capitalizing on those benefits isn’t as simple as diversifying for its own sake.

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What is home bias?

Home bias is the tendency for investors to prefer investing in domestic securities over foreign securities. While Canada only makes up four per cent of the global equity market, most Canadians invest more than half of their investments domestically. Factoring in other assets such as real estate, insurance and pension benefits, the true exposure for most Canadians to their home market is likely closer to 80-90 per cent.

For Canadian investors, home bias can result in portfolios with significant concentration and correlation risks since only a few sectors, including financials, energy, industrials and materials, make up almost three quarters of the S&P/TSX Composite Index, and the 10 largest publicly traded companies make up a significant percentage of the Canadian equity market.

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Benefits of geographical diversification

Global markets do not move in perfect sync. Portfolios with higher investments in foreign markets tend to be more stable over the long term compared to portfolios heavily focused on Canadian equities. This is because there is lower correlation within the portfolio. One reason for this is the changing performance of sectors over time. Sectors that outperformed in one decade often did not continue their success in the next, as seen with the financial and health-care sectors in the 1990s and 2000s.

Due to the Canadian equity market’s concentration in certain sectors, diversifying across different geographical regions allows Canadian investors to access various sectors. Investing outside Canada also provides better access to growth opportunities, especially in the technology and health-care sectors where Canada lags its global competitors. This diversification helps in reducing the volatility of returns over the long run.

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Currency exposure may also help reduce volatility in the long term, particularly during economic downturns. During times of global economic stress, the Canadian dollar tends to weaken relative to the U.S. dollar both because the Canadian dollar is linked to commodities and because the U.S. dollar is perceived as a safe-haven asset.

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The complexities of solving home bias

Despite the advantages of geographical diversification, you would be ill-advised to spread your portfolio among the world’s almost 200 countries. Not all forms of diversification are equally beneficial, and some kinds of diversification can lead to increased risk and significant underperformance, such as investing in Russia before the war in Ukraine began.

So how much geographical diversification is suitable? It depends on both what the next economic cycle may look like and the characteristics of one’s domestic market. For example, home bias was beneficial for U.S. investors during the 2010s bull market as the S&P 500 outperformed most other developed market indices. Combine that with the U.S. dollar appreciating relative to other global currencies during the period, and home bias was more beneficial than harmful for U.S. investors.

Looking ahead to the next cycle, if inflation remains elevated compared to the past two decades, home bias may be a positive for Canadians as real assets tend to outperform in such an environment. Since the Canadian equity market has greater exposure to the materials and utilities sectors compared to many other markets, a greater allocation to domestic investments may be the more sensible strategy for the next decade.

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Taxes are another consideration. Canadian investors have preferential tax treatment when investing in Canadian dividend-paying stocks. However, when investing in the U.S., investors will need to consider the withholding tax on interest and dividends. While there are methods that turn foreign dividends into tax-deferred capital gains, these strategies are complex and require assistance from an experienced financial advisor to be properly implemented.

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There are additional factors at work that one must consider: There are liquidity risks (in the form of wider bid/ask spreads in foreign markets), transaction costs (such as fees when exchanging currencies), currency risks, geopolitical risks, the respective appeal of each market’s valuations and personal circumstances (such as financial goals, cash flow needs and risk tolerance).

Seeking counsel

Some think the solution to home bias is as simple as diversifying for the sake of diversification by investing more of your money in foreign assets. However, the amount to invest, where to invest, positioning correctly for the next economic cycle, taxes, transaction costs, liquidity, currency risks, liability matching, age, financial goals, cash flow needs, risk tolerance, market valuations and which investment vehicles to use are all factors you must consider when deciding what portfolio allocation is right for you.

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With the nuances and complexities of managing all these considerations, having the counsel of a financial adviser can help you plan an investment strategy based on your specific circumstances. An experienced adviser can help you avoid chasing returns at the wrong time by tactically positioning your portfolio to take advantage of changing market conditions while guiding you through the different phases of your financial journey to help you meet your goals.

Andrew Feindel, CFA, CFP, CSWP, CIM, FMA, CPCA, FCSI, HBA, is a portfolio manager and investment adviser at Richardson Wealth Ltd. and the author of Kickstart Your Corporation (2020) and Kickstart: How Successful Canadians Got Started (2008).

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