A simple fix for investors' Canadian diversification nightmare

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Exposure to the U.S. stock market is almost mandatory for Canadian investors right now.

Not because U.S. stocks are going higher. Frankly, I have no idea where they're headed. What I do know is that the Canadian market is a diversification nightmare that can be addressed quickly and cleanly by mixing in some exposure to the broad U.S. market.

As of late April, financial and energy stocks combined to account for as much as 60 per cent of indexes that track Canada's stock market. Indexes that track strictly dividend paying stocks may have even more exposure to these two sectors. The Canadian market has always had issues with diversification. Nortel, commodity stocks and financials have at various times all had more influence that we'd like. That's a reflection of our economy more than anything – we're good at resources and banking, not so much at technology, consumer products and pharmaceuticals.

Don't give up on Canada – when the right sectors are firing, we rock. Instead, perform a diversification graft on your portfolio by adding the U.S. market. Say you used an exchange-traded fund tracking the S&P 500. To start with, you'd get a 20-per-cent weighting in technology through companies like Apple, Microsoft and Google. That compares to just 2.5 per cent exposure to tech in the S&P/TSX composite.

Financials are next in the S&P 500 at 16 per cent – not ideal for Canadian investors, but what can you do? Anyway, the third-ranked sector in the U.S. market is health care, at 15 per cent. In the Canadian market, health care gets a 5-per-cent weighting that is dominated by one stock, Valeant Pharmaceuticals. Other sectors where the S&P 500 shores up deficiencies in the Canadian market include consumer discretionary and consumer staples stocks. Another benefit of the U.S. market is the modest influence of commodity stocks. Energy and materials together make up 11.5 per cent of the index, compared to 33 per cent for the S&P/TSX composite.

Mixing Canadian, U.S. and international content is totally subjective, but an approach I've seen a lot is to divide the equity side of a portfolio equally among the three. Something to remember here is that you're not positioning your portfolio for a win in the next 12 months. Adding U.S. content is about something more important – addressing the diversification nightmare in the Canadian market.