Get clients to invest outside Canada

Some advisors structure portfolios to benefit from global diversification. Yet diversification neither assures a profit nor eliminates the risk of market loss. Two reasons for their partial immunity to home bias are:

• A solid grounding in modern finance; and
• An equilibrium view of markets.

Modern portfolio theory helps advisors recognize the benefits of diversification. But when the local market outperforms, clients could criticize portfolios designed with less domestic exposure.

At this point, home bias will collide with an even more potent behavioural influence: hot bias, meaning a desire for clients to invest disproportionately in whatever has been doing well. Hot bias added to home bias can be like pouring gasoline onto a fire.

Canadian investors recently endured a collision of home and hot bias.

The chart (see “Five-year annualized return difference”) shows the annualized return difference between Canadian and U.S. equities for rolling five-year periods from 1961 to 2012. For nearly 20 years, there was never a five-year period when Canada outperformed the U.S., yet Canadian investors maintained portfolios tilted towards Canada.

But from 2003 to mid-2012, the five-year performance spread reversed, with Canadian equities outpacing the U.S. As the hot bias fuel poured onto the home bias fire, the global trend toward less home bias didn’t hold here.

If Canadian investors didn’t reduce their home bias during a long span of sub-performance relative to the U.S. (1984-2002), why would they diversify away from home when stocks were soaring?

Canada has had a great run relative to the U.S. But all good things come to an end, and in 2012, Canadian equities underperformed the U.S. over a five-year period for the first time since 2003. Is this the beginning of another hard lesson?

Severely home biased investors should learn from the past three decades and consider committing a larger share of their equity portfolios to non-Canadian markets. Read more: When home and hot biases collide