Let’s say you want to invest your savings, and you want to buy some stocks as part of your investment portfolio. Which stocks do you choose?
Traditional wisdom says you should hold more of your own country’s stocks than stocks from a foreign country. That means Canadians should hold more Canadian stocks than U.S. stocks.
This makes sense, since investing in another country’s stocks comes with currency risk.
Let’s say that Brazil’s stock market goes down by 5%. Brazilians would suffer a loss of 5%, and end there, but what about Canadian investors?
What if the Brazilian real also went down, as currencies tend to do when their stocks go down. If the real went down by 3%, Canadian investors would suffer losses of 8%.
Indeed, banks and other financial advisors often advise their clients to hold more Canadian stocks than U.S. stocks.
RBC’s more conservative portfolios hold more Canadian stocks than U.S. stocks. TD’s portfolios give equal weight to Canadian stocks and the rest of the world’s, including the U.S.
However with MoneyGeek’s portfolios, from the least risky to the most, we recommend investing significantly more in U.S. stocks than in Canadian stocks.
While both U.S. and Canadian stocks have returned roughly 9% per year for the past 100 years, U.S. stocks have been less risky than Canadian stocks.
There are two main reasons for this:
1. The safe haven effect
Canadians might have trouble admitting this, but the U.S. is special among all the countries in the world. It’s considered the most powerful nation on earth, not just militarily, but financially as well.
As a result, it’s seen as the safest nation to park your cash when the world becomes bedridden with economic ills. In such times, investors have bought U.S. treasuries in droves.
Purchasing U.S. treasuries require U.S. cash. In troubled times, the demand for U.S. cash surges, lifting the U.S. dollar relative to most other currencies, including the loonie.
During the last financial crisis from September 2008 to February 2009, the U.S. dollar gained 20%. Over the same time, U.S. stocks lost some 43%, while Canadian stocks lost some 41%.
A Canadian investor would have lost 41% on her Canadian stocks, while losing ‘just’ 32% on her U.S. stocks.
Unlike with most other countries, the U.S. currency makes its stocks safer, not riskier.
2. Canada’s Dutch disease
Last year, the very influential OECD released a 128-page report that addressed whether Canada has Dutch disease. The answer: yes.
What is Dutch disease? It doesn’t mean there are too many Dutch people in Canada. It speaks to the phenomenon where a resource rich country becomes too dependent on its resource production to drive its economy.
Since Canada produces tons of valuable natural resources, like oil and copper, people want to hold Canadian dollars in order to buy these resources. This makes the Canadian dollar expensive relative to that of other countries.
Having an expensive currency makes everything in our country more expensive from other countries’ view.
Wages are more expensive, rent is more expensive, and so forth. This makes our other industries less competitive on the global stage.
These other industries shrink relative to natural resource production until one day we realize all we have left is resource production.
Are U.S. Stocks Safer Than Canadian Stocks?
While Canada still has healthy industries other than natural resource production, the imbalance is evident.
The TSX Composite Index is comprised of 26% ‘Energy’ (oil and natural gas), and 19% ‘Material’ (gold, copper, iron ore, etc).
‘Financials’ (the banks) also comprise 30% of the index, and you can argue that much of our banks’ health is linked to how well those Energy and Material companies perform.
By contrast, Energy and Materials industries comprise less than 15% of the U.S.’s S&P 500 combined.
There are two reasons why such high concentrations in Energy and Material industries should worry us.
For one, our economy is not very well diversified. A blow to just one of these industries can have a significant impact on our overall economy.
But perhaps more importantly, Energy and Materials are very volatile industries by their own right.
Natural resources like oil and copper are volatile. That is, their prices fluctuate up and down quite violently.
Recall during the financial crisis, oil went from over $140 per barrel to under $40 in just 6 months. That’s a much bigger crash than the one experienced by the stock market.
But to make matters worse, Energy and Material companies are affected even more deeply by the natural resource prices.
Let’s take gold. In April 2013, gold prices had briefly dropped by more than 7%, but gold mining companies were hit much harder than 7%.
Related: 4 Ways To Invest In Gold
For example, let’s say it costs a gold mining company $1,000/ounce to produce gold. Gold prices went down from $1,600/ounce to $1,476/ounce in April.
That means the mining company’s margins went from $600 per ounce to $476 per ounce. That’s a 20% drop in margins, much larger than the 7% drop in gold prices.
All things equal, if a company earns 20% less profit, it should be worth 20% less overall. For many smaller gold mining companies, it costs more than $1,000 per ounce to produce gold, which means their value dropped by even more.
The same can be said about companies that produce copper, iron ore, oil and gas as well as other natural resources.
All of this is to say, Canada’s economy stands on much shakier ground than that of our neighbours to the south.
Because of this, and the fact that the United States benefits from its safe haven status, U.S. stocks are actually safer than Canadian stocks. Even for us Canadian investors.
And for that, they deserve a greater share of our portfolios.
Dr. Jin Won Choi is the founder of MoneyGeek, an internet start-up that provides investment plans for Canadian young professionals. Dr. Choi has a Ph.D. in financial mathematics, and he’s worked as an analyst for a top performing fund for 2 years.