Canadians find comfort investing close to home. According to a 2014 study by the International Monetary Fund, Canadian stocks accounted for less than 4% of total global equity market capitalization, yet the average Canadian investor allocated close to 60% of their equity portfolio to domestic stocks.
Canadians are not alone in this regard. The preference to invest in one’s own backyard is a worldwide phenomenon, rooted in our natural tendency to take comfort in the familiar. Some studies suggest that home country bias is even more extreme in the United States, with upwards of 70% of American portfolios concentrated in local market stocks.
In theory, our affinity for familiar or well-known investments can be detrimental to our financial health. By staying close to home and/or investing in businesses that are familiar, investors could potentially miss the benefits of diversification. Foreign firms and less-familiar businesses often have attributes that can enhance portfolio returns, reduce risks or both.
Indeed, Canadians who diversified outside of Canada have been served very well in recent years. Over the last decade, Canadian stocks produced a total return of just 124%, whereas the MSCI Global Index yielded a total return of 240%. American stocks have done even better, with the S&P 500 Total Return Index appreciating by 354% over the same period.*
Nonetheless, our natural familiarity bias can be a good thing, as financial theory and human nature don’t always mix well in the real world. When we venture too far outside our comfort zone, we are more likely to make costly emotional mistakes. This is especially true during times of market turmoil.
Our experience has taught us that familiarity is often the best defense against emotional mistakes during market corrections. Investors are more likely to hang on to a familiar business during a market storm. We are naturally less inclined to panic when we know others share our misfortune. As they say, misery loves company. We are also more likely to believe that external factors beyond our control are responsible for our discomfort.
Conversely, when less-familiar stocks are caught in a market downdraft, we are more likely to have doubts, blame others or ourselves for the hardship, panic and sell.
Consequently, we believe investors would be wise to concentrate their investments in familiar companies.
While it’s okay to have some investments in less-familiar businesses, it’s probably best not to have too many. Ask yourself, what balance between familiar and unfamiliar securities will make you comfortable during the next inevitable market setback? While it can be difficult to adequately and appropriately diversify an equity portfolio with domestic stocks alone, Canadians are fortunate to be very familiar with many wonderful American companies. Not only is the U.S. stock market much larger than Canada’s, but there are many American-listed companies that offer significant global diversification via their international operations.
The caveat or caution to our view that investors should focus on familiar businesses, is that the most familiar businesses of an era can become too popular and pricy. That was the case with Canadian Resource stocks a decade ago, Technology and big American stocks at the turn of the century and the Nifty 50 group of most popular stocks on the New York Stock Exchange in the early 1970s.
While we don’t think popular and familiar businesses are too expensive today, it’s quite possible they will become overvalued down the road. In the interim, we believe investors would be wise to concentrate on familiar businesses. When the risk of emotional mistakes is considered, the better discipline that flows from the comfort of familiarity outweighs the diversification benefits of less-familiar investments.
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