During periods when global stocks have been outperforming Canadian stocks, I receive a growing number of questions asking why my model ETF portfolios are skewed so heavily towards Canadian stocks (as one might imagine, I receive the opposite feedback when Canadian stocks are outperforming global stocks). The argument usually goes something like this: Canadian stocks make up just over 3% of the global equity markets – shouldn’t Canadian investors simply hold a 3% equity allocation to Canadian stocks?
I’ll let you all in on a dirty little secret: no one knows the optimal amount of Canadian stocks that an investor should hold. Not me, not the talking heads on BNN, not anyone. All we can hope to do as mere mortal investors is to make a reasonable guess that we are comfortable with, and stick with it over the long term.
As mentioned, Canadian stocks make up just slightly more than 3% of the global equity markets. But in my model ETF portfolios, I overweight Canadian stocks by about 30% (resulting in a 33% allocation, or 1/3 equity weighting towards Canadian stocks). There are a number of good reasons for doing so, which I’ll cover in a series of blog posts.
If we assume that the future expected returns for Canadian stocks are similar to global stocks, rational investors would prefer a blend that results in the least amount of portfolio risk. In the graph below, I’ve calculated the historical volatility for various balanced portfolios between 1988 and 2015 (with a 60% allocation to stocks and a 40% allocation to bonds). Each portfolio along the curve overweights Canadian stocks by varying amounts.
To the far left of the graph, you’ll find a balanced portfolio that invests 100% of its equity component in Canadian stocks (you may also notice that it has the highest risk, or volatility, of all the portfolios). Most investors realize that this is an extreme position, and that significant diversification benefits can be achieved by investing some of their equities into global stocks.
As we move further along the curve to the right, we find that the portfolio risk bottoms out at around a 30% overweight to Canadian stocks (a similar mix to my PWL model ETF portfolios). As we continue to the far right of the curve, we reach the market capitalization-weighted index portfolio. Indexing purists will often argue that this is the most optimal portfolio, as it is the most diversified and requires no active decision-making. Contrary to what they believe, this portfolio has historically been more volatile than a portfolio that overweight Canadian stocks by 30%, or even 50%.
In their 2014 research paper that followed a similar methodology as the analysis above, Vanguard Canada was quick to point out that their analysis was backward-looking and particularly dependent on the time period examined. The specific asset allocation (the mix between stocks, bonds and other asset classes) also affected the historical results. Without knowing what the future holds, a reasonable starting point would arguably be between a 20% and 40% overweight to Canadian stocks.
In my next blog post, I’ll look at a number of other reasons that it may make sense for a Canadian investor to overweight Canadian stocks within the equity component of their portfolio.