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In a previous article, we discussed how Canadians hold too many Canadian domiciled stocks in their portfolio.

In short, the common excuse of holding Canadian stocks with U.S. revenues was not enough of a reason to justify this home bias. It is apparent that there is some home bias relative to Canada’s position in global markets (at roughly 4 per cent of global GDP).

So, there are reasons for having an overweighting in your home country, but what are those reasons?

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Dividends!

The dividend tax credit is one of the most cited reasons for having an overconcentration to Canadian equities, and this is fair.

Our concern, however, is that may have become a bit of a blanket rule of thumb that does not apply to everyone. The primary benefit, as we see this dividend argument, is if you are in retirement (or have a very low income), you can receive roughly $45,000 to $51,000 in dividends tax free in most provinces.

If this is the case for the individual, an argument can certainly be made to structure a portfolio that is heavier in Canadian dividend names than one might typically suggest, because all of the dividends being paid out are not taxed at all.

However, the reality is that this scenario likely applies to far less individuals than one might think.

First, you need a sizable investment portfolio to generate sufficient dividend income. To get to the cap of $50,000 and assuming a 4-per-cent yield, one would need $1.25-million in investable assets, all concentrated into one style of stock in one country. So realistically, to not risk one’s entire net worth on a single strategy, an individual would need far higher than this $1.25 million level in order to generate the maximum level of tax-free dividends while still maintaining some semblance of diversification in a portfolio. Secondly, if you need to withdraw from a RRIF and/or receive a bit of a pension elsewhere, the benefits of the tax-free dividends become diminished. So, while there is still some benefit to the tax credit, it really works best when one has essentially no income stream coming in. Regardless, for those who fit this scenario, there can be a real argument for some sort of overconcentration in Canadian equities.

Foreign exchange complications

Foreign exchange does throw a wrench into geographic diversification.

Having exposure to assets in other currencies can lead to higher short-term volatility (but arguably can smooth volatility in the long-term). It can also lead to increased costs through exchanging money back and forth, which tends to be costly and a bit opaque in terms of actual fees one pays, which is why the Norbert’s Gambit strategy has become so popular with investors.

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Finally, it does create some timing risks. If you need money “tomorrow” in Canadian dollars but need to convert it from U.S. dollars and the FX rate moves against you, you all of a sudden have less funds to draw down from. This, of course, can go both ways, but is an extra layer of uncertainty for investors that many simply do not want to deal with.

So, for these reasons (costs, volatility, timing issues), having a bit of home bias to lessen the FX impacts can make sense. Fortunately, there are many ETFs out there that help to hedge out the U.S. dollar exposure, so there are easy ways around this problem.

Knowing your own country better

We actually think that this is more of a misguided reason than anything, but it might make sense psychologically.

From the misguided point of view, the reasoning is that the investor understands the name better because they are “closer” to it or can feel and touch it. However, this also assumes there is a pretty big inefficiency in markets where investors around the world “miss something” that you in turn know better about your country and those stocks and have an edge simply by being able to “walk into the store.”

Like always, there are exceptions where experiences with companies can lead to great investments, but this probably just doesn’t make an argument for home bias overall.

Where this can be justified is through comfort and psychology.

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If an investor feels like they understand a Canadian bank better than a U.S. bank and will be better able to hold onto that bank in a 2008 scenario, some home bias can be justified.

If that home bias helps an investor make the right decisions and not stress about the portfolio, there is a strong case for it, in our view. Of course, like in all the examples, there is a fine line here where the psychological benefits can be outweighed at some point by the concentration risks.

Regardless, “understanding what you own” can be a reasonable justification for some home bias, just likely not the reason most investors think.

Age

This last item is a bit of a confluence of all of the above, but there is more justification for home bias when one is in retirement and withdrawing funds from the portfolio.

This includes lower volatility from foreign exchange when you need the funds, utilizing dividend tax credits, and likely simplifying the overall tax and reporting situation of the individual. So, for investors that are in a retirement situation with most or all of their expenses in Canadian dollars, a higher-than-usual allocation to Canadian equities might make sense.

We do want to be clear here: While there are some reasons that can justify the Canadian home bias, it still does not mean that on average extreme home bias is justified.

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Theoretically, if an investor has over half of their portfolio in Canadian equity, the portfolio is likely far over-weighted to a small geography in the global picture than it should be.

As we have outlined above, however, there can be some reasons either financially or psychologically that justify home bias in a portfolio. The key is determining what that right amount is, and ,unfortunately, there is no single right answer to this question. This is why investing and finance can be a frustrating yet rewarding experience where there is always something new to learn.

Readers can view more data on Canadian companies with U.S. revenues through a free trial to 5i Research here.

5i Research provides content under an agreement with The Globe and Mail, which receives royalty compensation.

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