Canadians are often criticized for being a fairly complacent bunch, and this is no less true when it comes to how we invest our money. Chief among these criticisms is the fact that the vast majority of Canadians seem entirely comfortable allocating the bulk of their equity exposure to domestic stocks, despite the fact that the TSX represents only 3% of global stock market capitalization. In fact, a 2017 study by Vanguard showed that while the Canadian stock market is miniscule relative to the rest of the world, Canadians collectively held nearly 60% of all their stock exposure domestically1.
This lopsided allocation to the TSX is often framed as a blind spot for Canadian investors, in that our home country bias prevents us from taking advantage of global growth and gaining exposure to the superior stock market returns that have historically existed in developed international markets outside of Canada. These criticisms are often accompanied by charts like the following, which shows how much better international developed markets have historically performed while taking on only a moderate amount of additional risk. US stocks, for example, achieved a real compound annual growth rate of 2.5% over and above that of Canadian stocks from 1972 to 2020, and all at the cost of only slight uptick in risk.
The main problem with the risk/return chart above is that it uses volatility as a proxy for risk, which is far from an accurate representation of how people in the real world actually perceive investment risk. Investors don’t care about volatility per se. What they care about are losses. While many people tend to conflate volatility and risk as being one and the same, the reality is that standard deviation fails to accurately measure the risk of actually incurring losses. A far better gauge of risk is one which incorporates the many different ways that average investors perceive investment losses, which is a composite measure of drawdown frequency, magnitude, and duration. We refer to this risk measure as an investment’s “total risk” (for details, see A Total Risk Portfolio Framework). If we now use total-risk as our risk-proxy rather than volatility, we’re left with a far different visualization of the risk/reward relationship for Canadian and US stocks.
US stocks still outperform Canadian stocks, of course, but they now do so with substantially greater risk. While Canadian equity still trails US equity by over 2.5% per year in real terms, the risk of substantial losses goes up dramatically, even if volatility doesn’t. For a raw visualization of the different risk profiles for Canadian and US stock markets, the following chart shows historical equity market drawdowns from previous all-time highs for the period 1972-2020 (all returns are shown in Canadian dollars).
The above chart clearly shows how frequently each investment has historically lost money, the magnitude of those losses, and the time it took to recover. While Canadian stocks may have exhibited slightly shallower drawdowns in the 70’s and slightly steeper drawdowns in the 80’s and 90’s, US equities have clearly become significantly more risky since the bursting of the Dot-Com bubble in 2000. The tech crash resulted in a 36% inflation-adjusted loss for US equities, versus only 26% for Canadian stocks. The real, difference, however, is that while the Canadian stock market reached new all-time highs as early as 2004, US stocks were still 24% off their 1999 highs prior to the financial crisis of 2007-2008. The financial crisis subsequently delivered further large-scale losses to US equity investors, punishing them with an incredible 47% total drawdown below their 1999 peak (after accounting for inflation). Indeed, the bursting of the Dot-Com bubble in 2000 marked the beginning of a 13-year drawdown period for US equities, which only finally recovered in 2013.
Lest the reader get the impression that this period of underperformance is solely a US phenomenon, non-US Developed markets also incurred significantly greater losses than Canadian markets during this period. However, whereas US markets took until 2013 to recover, non-US developed markets didn’t break even until 2015, a full 2 years later than in the US. For visualization purposes, drawdowns for Canadian equities and non-US Developed market equities are shown below (as before, all returns are shown in Canadian dollars).
So yes, global equities may have indeed outperformed Canadian equities, but they did so at a significant cost. A Canadian investing internationally would have incurred far greater drawdowns than had they simply stayed at home and invested strictly in the TSX. Canadian equities have historically been significantly safer than international stock markets, which undoubtedly provides significant advantages for risk-adverse investors. While it’s true that Canadians may have failed to achieve the gains of their international peers, the ride was undoubtedly a whole lot smoother.
Of course, none of this is an argument against international investing per se, as the future will inevitably differ from the past. We diversify, after all, precisely because we don’t know what the future will bring, meaning there is certainly a case to made that Canadian equity markets won’t be spared the type of large-scale losses of its global brethren the next time around. Having said that, it does appear from the historical record that the TSX tends to avoid the worst parts of the speculative manias that have characterized global equity market returns over the last 20 years. For example, many traditional valuation measures suggest that US stocks are currently grossly overvalued by historical standards. These same valuation measures, on the other hand, suggest that Canadian stocks are presently only moderately over-valued. While no one can guarantee that this this means Canadian equities have less downside risk than the US, there’s a good case to be made that Canada has currently managed to avoid the type of stock market excesses of other developed equity markets globally. It doesn’t mean stocks won’t fall here in Canada during the next market crash, but it does suggest that they won’t fall quite to the extent they will in the US.
One of the benefits of discarding the traditional volatility-based risk measure in favor of our “total risk” measure is that it allows us to dispel the notion that international equities are somewhat of a free-lunch for Canadian investors. The idea that US stocks deliver far greater returns with only a minor uptick in risk is false, regardless of the fact that Canadian and US equity markets have similar long-run standard deviations. If Canadian investors want to chase the return premium of US stocks, that’s certainly their prerogative, but the investment industry really ought to stop chastising Canadian investors for not holding the bulk of their equities in international markets. One would have to imagine that deeply engrained home country bias has probably done a lot more to keep Canadians invested through turbulent market environments than the global market cap portfolio often touted by many financial professionals. This isn’t to say that Canadians shouldn’t have some level of international equity diversification, but historically speaking, the TSX has been a far safer investment than global stock markets, particularly over the last 20 years. Yes, it’s true that Canadian stocks tend to underperform. And for many investors, given the massive reduction in risk, that’s just fine.