Have you heard of the Couch Potato portfolio? It’s a simple investing model I’ve really liked over the years. But there’s one thing that bothered me; the Canadian market was given the same weighting in the allocation as the US and international markets. Noah Solomon, from Outcome Wealth Management joins us on the show to discuss how Canadians are overinvesting in Canada whether they’re following The Couch Potato portfolio or simply choosing stocks and mutual funds. Plus, we discuss how to become more diversified leading to stabilized returns and less risk.

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Tom: Hi Noah, welcome to The Maple Money Show.

Noah: Thank you very much. Thanks for having me.

Tom: On the show we’ve talked a lot about index investing, robo advisors and ETFs and I’m a big fan of all of it. But what one spot where I think we’ve had conversation in Canada is that maybe we’re going a little wrong. Maybe we’re a little too overinvested in Canadian stocks. Just right off the bat, what are your thoughts on a normal couch potato portfolio where it’s one third Canadian, one third US and one third international?

Noah: You’re right; Canadians are over-weighted to their own equity market. Canada’s somewhere between three and four percent of the global stock market. The couch potato portfolio that you referenced has a little over a third invested in Canadian equities. Although, at least in a relative sense, the couch potato portfolio was actually underweighted to Canadian stocks. Not relative to the world index but based on surveys, Canadians, on average have an estimated 60 percent of their portfolio invested in Canadian stocks. And even though the couch potato portfolio is over-weighted, it’s less over-weighted than other Canadian portfolios. The overweighting, your own country’s stocks, is not a uniquely Canadian proposition. It’s known as the “home country bias” or the “home equity bias” and the good news is we’re no more or less guilty than other people. Almost every people overweight their own country’s equities in their portfolios. And we’re no different than that. The explanation is that people basically like to invest in things they know. So, if you’re a Canadian and you see Royal Bank or TD on every corner—it’s familiar to you so you’re more comfortable investing in it, although there’s no economic rationale for it. There’s actually an economic rationale not to be overweight and to be more diversified. It’s a common thing that comes from an emotional bias because you invest in what you know and what’s familiar to you. But as I said, we’re no different than anybody else.

Tom: Yeah, that makes sense mentally. Like the Warren Buffett advice of “invest in what you know” such as having your Coca-Cola stocks and stuff. What was it 60 something percent normally?

Noah: Based on some preliminary research I’ve done in some surveys they suggest around 60 percent. In terms of being guilty of overweighting Canada, you could say the couch potato portfolio was one of the taller midgets in the room.

Tom: Yeah, exactly. I don’t mean to knock it. I pretty much do it myself. Sometimes I get a little out of ETFs within Canada but ultimately it’s still good that someone gets started. If you’re going to go a third, a third, a third and maybe some bonds, it’s still a great way to get started. I don’t want to knock it completely.

Noah: No, I think it’s a very practical efficient way of investing for most people. It’s probably better than what they’d be doing otherwise.

Tom: Obviously, as you start to invest more and more money this is going to start to matter more. What do you see as a difference in returns with something like the couch potato or the 60 percent that Canadians have just started doing naturally compared to an entire world index?

Noah: The funny thing is the longer your time horizon goes then the more the stock market performance of any country start to all look like one another. And what I mean by that is over shorter time periods—a year, three years, even five years, Canada can do much better than the US or much worse than Europe. Or Japan can outperform both of them. There can be massive dispersion in the returns of different countries where they can massively underperform one another. But as you get longer and longer and longer in terms of your holding period, they start to converge and those differences start to basically approach zero. So if I had a 200 year horizon (just using a silly example) in theory, being 100 percent weighted in one developed market versus being diversified across all of them won’t make a huge difference in your return. Which is interesting because the next question is obviously, why does it matter? Why shouldn’t I be over-weighted if I have a very long time horizon? And I’m happy to get into this.

Tom: Yeah, let’s get into it right now. I want to show people the benefits of looking at this a little bit differently than they might be right now.

Noah: I’m going to sort of take a step back and give you some perspective. As it turns out, most of us—most rational people employ a certain mindset in their daily consumption patterns. Yet, when it comes to investing they completely abandon that rational mindset. And what I mean is this; let’s say you are looking for a pair of shoes or a suit or a car. If you were a rational person you would generally endeavor to buy the best pair of shoes or car or coat that you could for the least amount of money. That’s what constitutes value. You want to get the most and pay the least. Now when it comes to investing they completely abandon this logical framework. With investing you don’t get a pair of shoes or a car or a coat. You get returns. What you pay is fees. And yes, they are important. But what people often forget is what you also pay is risk, volatility. Just like you want to get the best pair of shoes you can for the least amount of money, you want to get the highest returns you can by taking the least amount of risk. When it comes to investing people abandon this mindset. They do focus on return but they often don’t focus enough on risk. The returns, if you have a very long time horizon of any country, start to converge towards each other. They’ll all start to lose the same. But, when you diversify, you will lower your volatility. In any given year one market does great while another market does less great or poorly and you don’t know which one’s going to do well. You don’t have a crystal ball which is a pretty good assumption, so by diversifying, over the long-term you won’t change your return necessarily, but you will lower your volatility and reduce your risk. And if you’re going to get the same car wouldn’t you rather pay less for it? You’re going to get the same return so do you really need the headache of extra volatility? Or would you rather get just the same amount of the good thing with a lot less of the bad thing? It’s just logical. I think Eugene Fama, who won the Nobel Prize said, “Diversification is the only free lunch.” So, why wouldn’t you eat a free lunch?

Tom: So it’s not so much about returns then. It’s about smoothing that out and reducing that risk?

Noah: Well, it is certainly, but there is a little bit of return element to it. Imagine two investments and they both get a five percent return over every three year period. But the first one goes 5, 5, 5, 5, and 5. The next year it goes 5, 5, and 5. The other one goes 5, 10, 0, 5, 10, and 0. They both have the same average return every three years which is five. One obviously has no volatility. It’s five percent every year. And the second one has much more volatility. Because of the way compounding works even though they have the same simple average returns, the one with lower volatility will compound much better over time. That’s actually called the diversification premium. You’re actually getting more of the good thing by diversifying and less of the bad thing. So you’re actually getting a better pair of shoes for less money. So who wouldn’t want to do that?

Tom: If someone was just a do-it-yourself investor, how would they start something like this? Are there certain ETFs that you would use to build a better portfolio?

Noah: Well, let me go back to that home country bias that you brought up and how Canadians are way overweight couch potato 30-something percent compared to Canada’s 4 percent weight in the global index or your average Canadian which by all surveys is around 60 percent investment in Canadian stocks. As I said, we are not different than other people but “sin” of overweighting your home equities is a greater sin in Canada than in other countries. And the reason it’s arguably a worse thing in Canada than in other countries is because the Canadian stock market itself is far less diversified than other markets. The top 10 companies—the 10 largest companies in the TSX make up about a third of the index. In the US it’s nowhere near that amount. Or even in Europe. We have massive sector concentrations. We basically have financials dominated by the big banks. We have energy because we’re a big energy producer. And we have materials. Those three sectors account for about 75 percent of our stock market. What we don’t have is things like—we are almost negligible in technology, health care, consumer discretionary, consumer staples. So not only when you’re over-weighted in Canada are you failing to diversify by geography, you are also failing to diversify by company and sector because of the individual company and sector concentration. As I said, if you’re an American and you’re over-weighted in your home equities that’s a lot less bad than being overweight in Canadian equities as a Canadian because of the lack of diversification inherent in our economy and our index. Now historically, I could argue there were some pretty good reasons for having that home equity bias which I’m happy to go into, but also why those reasons have gone away today. There’s really no good reason.

Tom: So what are the pros for this bias? Because I totally get what you’re saying about the lack of diversity in Canada.

Noah: Using the old expression, “We are drawers of water and humours hewers of wood,” or something like that.

Tom: The stocks I hold in Canada are basically financial and utilities. There not much else. I think I have some construction as well but that there’s not a lot going on.

Noah: No, no there’s not and there’s no way around that in the near-term so the only way to diversify sector wise is to get out of Canada. Just from a risk management perspective, being diversified is good but you also miss a lot of opportunities. As we all know, the technology sector—the FAANG stocks have been world leaders. We don’t really have any significant publicly traded stake in that area— in that space. So by definition, you have to leave Canada to get exposure to those opportunities.

Tom: Exactly. Can we go into what FAANG is just so that we’re not leaving anyone behind?

Noah: I think it’s Facebook, Alphabet, Apple, Netflix, Google. It’s the technology stuff.

Tom: I think you’ve got it. It’s back before it was Alphabet.

Noah: But even health care. You think of things like Pfizer, these huge companies like Johnson and Johnson and Merck. We don’t have any of these companies that can and probably will discover some great new treatments and medications especially with an aging population in the developed world. We don’t have any of those health care stocks. You need to leave Canada to get exposure to that.

Tom: We talked a bit about the benefits of American stocks. What about international or even the emerging markets that everyone seems to love for the best hope of return?

Noah: Well, there are two different questions. In terms of the international stocks, Europe for example, if you’re a long-term investor what we see today is that Europe certainly has its problems. It has anemic economic growth. It has some political problems—some political uncertainty and unrest not least of which is Brexit. At the same time, one could argue that’s in the price. They’re trading at much lower multiples than their US counterparts. And usually, at least for long-term investors where you start in terms of valuation, is a pretty good indicator of what your long-term returns will be. So there may be some bargains in Europe that you just won’t find in North America because of what’s going on there. There may be some interesting pickings within the hurricane that’s going on there. Emerging markets is a different story. I think everyone’s pretty aware that these economies over the next 20, 30 years will be a much harder percentage of the global economy. Their economies are growing at five or six percent a year and they trade at lower valuations. Now, they are volatile. They can be a lot more volatile than developed, but certainly for a long-term investor it’s hard to argue that these things won’t be a larger and increasingly larger share of global equity portfolios in emerging. There is tremendous long-term opportunity because their growth is higher than in the developed world and they trade at much lower valuations. So there will be noise along the path, but for long-term investors not to have a decent exposure to emerging markets is probably not a good idea.

Tom: Yeah. I guess even though there’s a risk to it that’s the whole point of this diversification talk isn’t it?

Noah: Yeah, you shouldn’t back up the truck and put 100 hundred percent in emerging markets. But to have 10 or 20 percent weighting in emerging markets if you’re a long-term investor and you don’t care what happens tomorrow or next year, would probably be a good idea.

Tom: Speaking of the backing up the truck, there’s a guy I know that’s basically entirely invested in Apple. At least that’s how he lets on—that his Apple investments have been doing so great and he’s going to be set. Personally, I don’t invest directly in tech stocks because I can’t take the time to follow them. What’s the benefit of ETFs just in general to help with this diversification?

Noah: You’re into an interesting thing and this is sort of the idea of stock picking versus indexing in a nutshell, especially in your case. Your friend who owns Apple is a very concentrated stock pick. What’s interesting is stock picking is hard. Not just because you have to spend the time but even if you look at professional stock pickers—people who spend their whole lives doing this… mutual fund managers. The fact is the vast majority (net of fees) underperform the index. That’s not my opinion. The data is very clear that over a 10-year period (and this is quite consistent) 90 percent of active managers, after fees, underperformed their benchmark. That’s a pretty consistent number. Your friend certainly made a wonderful decision but he is not common. Ninety percent of the pros underperformed their benchmark over a 10-year period. Hence, the rise of indexing. And that’s probably why—even to the point where Warren Buffett has said, “When I leave this earth most of my money is to be given to charity. But the money I intend to leave to my wife is to be invested in the Vanguard S&P 500 index fund because I would not pay a manager fee.”  

Tom: It makes sense with so many mutual fund managers out there, they’re basically the market. So how are you going to beat yourself? On the whole they are the average, right?

Noah: That’s right. They’re not only competing with the index, they’re competing with each other because inherent in those index prices, are all of them.

Tom: I made this mistake early on in my own investing. I had just finished college and I was a financial analyst. I thought I knew this stuff and was buying so many different mutual funds. I was really indexing before it was a popular thing. I knew I needed diversification so I bought all these different mutual funds. But it was getting dragged down by fees. I was paying something like two and a half percent in fees or more. I thought I so well diversified and I was, but really a few ETFs or index funds at the time would have probably done the job.

Noah: We did an analysis and in our minds investing is really 99 percent about harvesting the magic of compounding. Long-term investing is all about compounding. Compounding is the magic that creates wealth. And fees are antithetical to compounding. They hurt your compounding rate. So if you were paying let’s say a 2 percent fee, depending on what your average returns were over a 20 or 30 year period versus let’s say a half a percent fee, I figure on a pre-tax basis (depending on the assumptions) they’re taking about a third of your returns. You don’t think about it that way but through compounding over 20 years you’re dying by a 1,000 paper cuts. They’re taking a third of your retirement. That’s serious business.

Tom: I agree. It just doesn’t make sense to me anymore. I’ve been very pro-indexing and pro-robo advisor because, again, it gets people started whether you want to follow the coach potato method or this more global allocation. Just get started and keep the fees low.

Noah: What I would say about ETFs is you hear a lot of attacks on ETFs. They’re this—they’ll blow up and they haven’t been tested… Whatever the reason, you can’t paint all ETFs with the same brush. First of all, the people who are who are criticizing ETFs in many cases have a bone to pick because they’re part of the active management industry that is getting its lunch eaten by ETFs. Don’t ask a barber if you need a haircut because they’re biased. Aside from that, again, you can’t paint all ETFs with the same brush. So, when they say ETFs are this or ETFs are that, it’s not fair. ETFs, in many senses, are no different than any financial innovation over the last 100 years. What do I mean by that? Generally, they start off as a good idea and then ultimately the financial industry perverts that good idea into some horrible mutated form. The original ETFs—the broad-based, index-tracking ETFs like the S&P 500 ,TSX 60 or whatever, were a good idea then and they’re a good idea now. And at the end of the day, they will wind up engendering a massive transfer of wealth from the investment management industry to investors. And there’s nothing wrong with that. However, they have been perverted. Now you have these inverse triple leverage ETFs. Those things are, in many cases, toxic. Again, to paint all ETFs with the same brush is not right. But sticking with the more broad-based liquid, low-cost, index-tracking ETFs were a good idea then and they’re a good idea now.

Tom: Yeah, some of these ETFs have come up in the last five to 10 years. And now, they’re kind of like mutual funds in disguise. The fees are going up and they are a lot more actively managed. So it’s not really an ETF anymore anyways.

Noah: It’s funny all they’ve done is shift to get deck chairs. So, in a sense, what we know from the data is that in mutual fund space the vast majority of managers (on a net basis) underperform the index. I am sure in 10 or 20 years from now I am quite confident that you will hear the same statement but it will sound something like this; the vast majority of non-index-tracking ETFs or actively managed ETFs underperform the index-tracking ETFs. To your point, it’s the same thing; passive versus active. I don’t care if you call it a mutual fund, an index mutual fund versus an actively managed or an active ETF versus an index-tracking ETF; it’s the same thing in a different form. Passive generally wins.

Tom: Yes, and it’s easy for people to see the difference because all they have to do is look at the fees they are requesting and they know exactly what’s going on.

Noah: I’m not really biased on whether you buy the Vanguard S&P 500 index mutual fund or the ETFs. They both capture the same good stuff. They’re low-fee, liquid. They track an index and they’re not picking stocks.

Tom: Exactly.

Noah: There were a couple of comments I wanted to leave you with though in terms of why today is different in regards to your home equity bias. In the old days, exchange rates could be a huge source of risk and volatility. So if you invested as a Canadian in US stocks even if the stocks didn’t move up or down a penny, if the Canadian dollar rose 10 percent against the US you just lost 10 percent. Currency risk was a huge thing. That has gone away because now you can buy ETFs that have the hedge inside of them. They’re currency hedged. Plenty of ETFs. You can buy the S&P 500 and Canadian dollars which is hedged so that goes away—that old concern of not wanting to go outside of Canada. The other thing was currency conversion. If you wanted to buy US stocks you had to take your Canadian money, convert it to US to buy US stocks and you got murdered on that conversion. You went into the bank and they typically spread you three percent for nothing. On the most liquid market in the world, they took three percent. Then when you sold your US stocks and wanted it back in Canadian, they took another three percent. So you’ve started underwater by six percent before you’ve even done anything. And by the way, that’s no different today. Again, today you can buy currency-hedged ETFs and not have to cross that horrible spread. They hedge for much lower cost. And the other reason you’d want to diversify is when you look at how most managers underperform—in Canada, when you look at Canadian domiciled managers who manage foreign exposure, it’s not 90 percent that underperform their benchmark whether it’s the S&P or Europe. It’s about 95 or 97. It gets even worse. Canadian managers don’t have a very good track record when they’re managing foreign equity exposure. That’s another reason to buy foreign index ETFs. So far I’ve told you all the reasons why you should be more diversified. You’d be silly not to reduce risk and you increase your long-term return. There is one reason why you would be overweight in Canadian stocks.

Tom: And what’s that?

Noah: That would be with tax. Canadian dividends are taxed at a lower rate than foreign dividends. That’s sort of an artificial thing that the government has created but it would be one argument that still exists for being slightly overweight Canadian stocks. Not 60 percent overweight but slightly overweight because you get a tax break.

Tom: Would that just be outside of the registered accounts?

Noah: Yes. To get a little bit of a tax break and be 60 percent weighted in Canadian equities is a mug’s game. That’s a bad trade. That’s the tail wagging the dog. But you can be somewhat overweight Canadian equities.

Tom: Yes, exactly. Another similar thing I do is keep a lot of my Canadian ETFs in stocks outside of my RRSP and TFSA for that reason. You called it exactly—the tax benefits are there so I keep the other things in the RRSP.

Noah: Yeah.

Tom: This has been a great look. Can you tell people where they can find you and how you can help them out?

Noah: Yeah, we have a website; outcomewm.com. They can look us up on LinkedIn.

Tom: Well, thanks for being on the show.

Noah: Yeah. Thanks very much.

Thanks Noah. That was great look into how we can better diversify our portfolio. You can find the show notes for this episode at maplemoney.com/noahsolomon. If you’re enjoying the Maple Money Show on iTunes, please leave us a rating and review. Not only can it help the show grow, I read all the reviews because I really want to know what you think. Thanks to you for listening. Next week we’re going to have Paula Pant on the show where we’ll be discussing how to escape the 9 to 5. Hope to see you there.