The Globe and Mail

Most Canadians' retirement portfolios have less international diversity than the average urban street corner. Michele Gambera thinks our investments should look more like the United Nations.

Mr. Gambera, chief economist at Chicago-based investment consulting firm Ibbotson Associates, said yesterday that in order to take full advantage of geographic diversification as a long-term investment strategy, "Any North American investor should have a foreign equity exposure that is, at a minimum, 25 per cent, and at a maximum, around 50 per cent." And within North America, he said, an investor should favour the U.S. market over Canadian stocks, in order to both have a representative weighting of the two markets and maintain more balanced industry-sector weightings.

So where would that put the weighting of Canadian stocks in a geographically well-diversified portfolio? Between 10 and 20 per cent is "about what I would have in mind," he said.

But as Mr. Gambera told an audience at the Morningstar Investment Conference in downtown Toronto, investors not just in Canada, but all over the world, are gripped with "home bias" - they invest far more in their home market than makes sense, given the well-established benefits of global diversification.

"International diversification is a very handy thing," he said, noting that it both boosts returns and reduces risk over the long term. But while this suggests that we should all model our portfolios after "a very broad international index"- such as the MSCI All-Countries World Index, a weighted index of 46 country's equity markets around the globe -"What works in theory very often doesn't work in practice."

That's certainly the case in Canada. Although the federal government's 30-per-cent limit on foreign content in registered retirement savings plans was eliminated two years ago, most Canadians' retirement portfolios still reflect those old limits. According to statistics from the Investment Funds Institute of Canada, foreign holdings made up about 25 per cent of total assets held by Canadians in mutual funds at the end of 2006.

Mr. Gambera acknowledged that Canadians' geographic diversity continues to suffer from the hangover of the foreign-content restrictions. However, he noted that even in the United States, where no such limits have existed, investors have been reluctant to fully diversify internationally. He noted that U.S. investing guru John Bogle now recommends that U.S. investors diversify up to 20 per cent of their portfolios outside of the United States, even though the U.S. market makes up less than half of the MSCI index.

Mr. Gambera acknowledged that there may be legitimate reasons for some degree of a home bias. Foreign investing generally carries higher transaction costs than doing business at home, and in some cases there may be little advantage to buying a foreign stock that has a similar business to that of a domestic stock. Many large companies already offer investors significant foreign exposure through their international operations. And from an economic point of view, he said, the fact that investors will be buying many essentially non-tradable goods and services with their retirement savings (like a haircut, for example) means that they may need less exposure to foreign markets to protect the buying power of their savings.

Mr. Gambera acknowledged that his long-term diversification strategy can cost investors in the short term, by failing to maximize their exposure to the hottest markets.

However, he said there is significant risk in trying to time geographic weightings in an attempt to cash in on out-performers.

"The safer position is the diversified position," he said.

"Do not diversify internationally for the wrong reasons - because you're chasing returns. [Diversify] to have a better portfolio."

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Global diversification

To establish a rule of thumb for how much global diversification is optimal, Ibbotson economist Michele Gambera's research has focused on two measures: The MSCI index, which represents a theoretically perfectly balanced portfolio of the world's equities; and an economic formula known as OPEN, which attempts to measure how exposed a geographic region actually is to foreign markets by adding its imports to its exports and dividing the sum by the gross domestic product.

He believes the OPEN measure generates a reasonable minimum foreign exposure an investor in a region should have (that is, 25 per cent for N.A.), while the MSCI serves as a reasonable upper limit (about 50 per cent for N.A.).