O Canada! The Impact of Home Country Bias on Investment Returns
As an Americanadian (pronounced A Merry Canadian) – an American citizen living in Canada – I’ve learned to embrace the Canadian lifestyle.
I learned to ski.
I enjoy a hot plate of poutine.
I occasionally say “Eh.”
I know MOST of the lyrics of O Canada. Except the French part.
I “get” curling.
And I’ve fallen into the trap of home country bias in investing.
Home country bias is the tendency for an investor to overweight equities in their home country at the expense of foreign securities.
Canada’s Share of the Global Equity Market
In terms of its impact on global equity markets, the US dwarfs its northern neighbor. The Canadian market accounts for approximately 3% of the world’s equity markets, while the US accounts for almost 50%.
Yet, home country bias dominates the investment portfolio of the average Canadian investor.
According to Vanguard,
The Canadian stock market makes up about 3% of world markets, however, Canadian securities on average comprise more than 75% of Canadians’ investment portfolios.
What Creates Home Country Bias?
There are several reasons why individuals favor investments close to home:
Familiarity. We naturally tend to invest in companies with which we are most familiar.
Perception of risk. Investors often incorrectly perceive foreign investments as more risky than domestic investments.
Loyalty. As Warren Buffet once asked, “Why not invest your assets in the companies you really like?”
Currency fluctuations. The returns of foreign investments may be impacted by fluctuations in exchange rates.
How we Invest in Canada as Americanadians
It is easy to fall into the trap of home country bias while living in Canada.
Of the 25 mutual funds offered through my husband’s Registered Retirement Savings Plan (RRSP), 5 are dedicated exclusively to Canadian equities.
Of the remaining funds, most are overweighted in Canadian stocks. For example, one of the choices, the Fidelity Clear Path 2045 (a target date fund), has approximately 20% of assets invested in Canadian stocks. Remember that Canada makes up only 3% of the world’s equity markets.
The most widely held fund in the RRSP is invested entirely in Canada, a Canadian Equity Small Cap fund.
This reinforces the findings from Vanguard: the average Canadian has 75% of their investment portfolio dedicated to Canadian equities, although the Canadian market represents a fraction of the world’s equity market.
Impact of Canadian Home Country Bias on Investment Returns
To see how home country bias toward Canada has impacted our investment returns, I compared the returns of the domestic stock market in Canada with the returns of the US and the global market over the last 10 years.
Although many people think that the economies of the US and Canada are inextricably linked, there are years when the returns from the TSX (Toronto Stock Exchange) Composite Index and the S&P 500 Index sharply diverge.
We moved to Canada in 2011. Since then, the Canadian equities market has underperformed the US and the global equities market every year except 2016.
This underperformance is in part due to the sector weightings in each of the domestic indices. Currently, the most heavily weighted sector in the S&P 500 Index is Information Technology. In contrast, the most heavily weighted sectors in the TSX Composite Index are Financials and Energy.
For the average Canadian investor, home country bias has negatively impacted their investment portfolio over the last 10 years. While the US market has seen great gains during the period, Canadian returns have been lackluster.
The average annual return of the TSX during the period is 4.8%.
Using Vanguard’s statistic that the average Canadian investor has 75% of their investment portfolio allocated to domestic stock, the overall portfolio return is 5.6%. This assumes that the remaining 25% of the investment portfolio is invested in the global equities market, with an average annual return of 7.8% over the last 10 years.
However, by decreasing the amount of Canadian home country bias, the overall investment performance improves.
If 50% of the equity portfolio is dedicated to domestic stocks, the average annual return increases to 6.3%.
If the portion of the portfolio invested in Canadian stocks is reduced to 25%, the average annual return rises to 7.1%.
By decreasing the amount of exposure to domestic stock (reducing the home country bias), the average annual return of the overall investment portfolio increased by almost 2.5% during the period.
The Bottom Line
Investors who practice home country bias may miss global opportunities and face a greater concentration of risk in their portfolios. As the comparison chart for the past 20 years indicates, outperformance of any domestic equity market is often followed by a period of lagging returns.
A broadly diversified portfolio helps decrease volatility and mitigate downside risk of overweighting the portfolio toward any specific region or sector.
It is possible for an investor to have unintentional home country bias. By checking the underlying assets of mutual funds, an investor can ensure they are not overweighted in one geographic region.
It pays to have a broadly diversified portfolio. Portfolios which include exposure to various geographical regions and sectors increase the potential return over the long term.
In our case, we reduced the amount of my husband’s RRSP dedicated to Canadian stocks. By looking at the underlying assets of each of the funds, we were able to determine exactly how much of the overall portfolio was allocated to Canadian equities. By rebalancing the portfolio, we achieve a balance with which we are comfortable: approximately 10% dedicated to Canadian equities. Much less than the 75% most Canadians have allocated to domestic equities in their overall portfolio.
Notes: Data for the global market performance was extracted from the Morgan Stanley Capital International (MSCI) World Index, a broad global equity benchmark which measures the performance of large and mid-cap equity performance across 23 developed countries. Data for the US market returns was extracted from the S&P 500 Index. Data for the Canadian market returns was extracted from the TSX (Toronto Stock Exchange) Composite Index. Dividends are not included in the calculations.