Note: This article is part of Morningstar's 2015 Global Equities Week special report.
The famous investor Peter Lynch popularized the concept of "buy what you know" as simple, intuitive advice for the average investor. Canadians, like local investors in other markets, tend to heed this advice and favour domestic stocks over global ones in what is referred to as home country bias.
The problem, though, is that sometimes what you don't know is better than what you do know. While there are some reasonable arguments for favouring domestic stocks, such as a short investment time horizon or income requirements, often home country bias stems from historical quirks, behavioural biases and a misunderstanding of the risk of investing globally.
Home country bias is the tendency of an investor to concentrate their portfolio in markets within their home country. For Canadians investing in stocks, a home country bias would mean holding a greater percentage of Canadian equity than what a foreign investor would hold. It's commonplace for Canadians to have more in Canadian stocks than foreign stocks, but you'd be very hard-pressed to find someone outside Canada with this same positioning.
To be sure, this bias is not unique to Canada. Investors in other countries such as Australia, the United States and the United Kingdom also possess similar preferences for their own domestic markets.
To put Canada's bias into perspective, consider that as of Sept. 30, 2015, the Canadian equity market represented just 3.4% of the market capitalization of the MSCI World Index, which spans all the developed economies including the U.S., UK, Europe and Japan. That number shrinks to 3% if you include emerging market economies such as China, Brazil, Mexico and India. Contrast that percentage with an estimated 62% average allocation to Canadian stocks by Canadian investors (as per data from the International Monetary Fund and World Federation of Exchanges, as of Dec. 31, 2014) and we get a better sense of what home country bias means in the Canadian context. Why then are investors disproportionately tilting their portfolio to domestic stocks and underweighting the global universe?
Reasons for home country bias in Canada
Part of the reason lies in history. Until 2005, the federal government restricted tax-sheltered pension plans such as RRSPs and group pensions from investing more than 30% of their portfolio in assets outside Canada. As a result, investors had the vast majority of their holdings in Canada (at the end of 2004, Canadians held around 75% of their equity investments domestically). And while the bias has come down following the removal of the foreign property rule, there certainly hasn't been a wholesale shift to global investing.
Part of this is due to inertia; it takes time for investors to adopt new allocations. The strong returns in Canadian equities in the mid-2000s and into the earlier part of this decade no doubt also kept money from leaving Canada. But those returns were achieved on the back of a commodities rally which, for the time being anyway, is all but over.
Another factor is behavioural and relates to the familiarity investors have with companies in their own country. Rightly or wrongly, this familiarity provides comfort to many and gives domestic stocks the appearance of safety and lower risk even though that may not be the case. For example, an investor may be more comfortable investing in 
Loblaw (L), a grocer they know because they shop there, rather than investing in Morrison Supermarkets (MRWSY), a UK grocer that they may have never heard of, let alone shopped at. However, a personal familiarity with a business has little bearing on whether it is a good or low-risk investment.
Aside from behavioural impediments, there are more rational reasons for an investor to allocate more domestically than globally. Foreign currency exposure can harm returns, especially over shorter time horizons. Thus, investors with short-term financial obligations in Canadian dollars have good reason to avoid this risk.
Higher fees and higher taxes are also impediments to higher global allocations. The median management-expense ratio of Canadian equity funds in the fee-based channel clocks in at 1.22%, which is 0.13% lower than the median MER of global equity funds. This is not a trivial difference, as the benefits of adding more global content has to be weighed against the extra costs involved.
Further, for those who hold investments in taxable accounts, the dividend tax credit on Canadian dividends is an incentive to keep money within Canada, and the dividend withholding taxes applied by foreign governments will widen the return gap between Canadian and global equity (all else being equal). Withholding taxes represent a drag on returns of approximately 0.4% a year (assuming withholding tax of 15% and a dividend yield of 3%).
Reasons to increase exposure to global equities
Diversification and a reduction of risk are touted as the main benefits to expanding to a global opportunity set when investing. There are two pillars to this argument. Firstly, there are thousands of companies outside of Canada operating in different markets, many with no ties or exposure to Canada. While all stocks are exposed to macroeconomic factors, stocks in different countries will have their own stock-specific or regional drivers which differ from those of Canadian stocks. Over the long term, these differences should work to reduce risk in a global portfolio.
Secondly, within Canada, the stock market is concentrated by sector and by stock. The S&P/TSX Composite Index is dominated by the financial services, energy and materials sectors, three economically sensitive sectors that combine to make up roughly 65% of the index. By comparison, the largest three sectors in the MSCI World Index (financials, information technology and health care) equal just under 32% of the index. Further, the number of stocks available in each sector is also striking. In Canada, for instance, the telecom sector has a 5.4% weighting in the index, concentrated in 4 names. In the MSCI World, the telecom sector has a smaller weight at 3.4% but at 42 names, it has 10 times the number of companies. It's a similar case for the health care sector, which has five stocks in the TSX compared to 124 in the MSCI World.
The TSX is also concentrated by individual securities. The top 10 stocks represent 38.4% of the index in Canada whereas globally, the top 10 stocks comprise 9.6% of the index. What this means is that one sector or even one individual stock can have an outsized impact on the Canadian market than would otherwise be the case globally. Declines in the energy and mining sectors and the sell-off in Valeant Pharmaceuticals (VRX) are just some recent examples.
Does it pay to invest globally?
Global diversification won't pay off in every environment, of course. The Canadian market will naturally go through periods of underperformance and outperformance, and currency movements will affect the returns of global markets in Canadian dollars, for better or for worse. In 2007, for instance, the MSCI World Index rose by 5.2% but in Canadian dollars it lost 7.1%. At the same time, the TSX was up 9.8%, illustrating that global diversification won't always be rewarded. The opposite has been true so far this year as the MSCI World through October is up 15.1% in Canadian dollars while the TSX is down 5.2%.
Over the very long term however, foreign currency adds an element of diversification and has been a net positive for Canadian investors. To the end of October 2015, the MSCI World Index in Canadian dollars has returned 10% annualized since January 1970, whereas the local currency version of the index has returned 8.9% (for comparison, the TSX returned 9.1%). Further, the index in Canadian dollars has experienced comparable volatility, with a standard deviation of 13.4% compared to the local currency index of 13.9%.
This analysis is susceptible to time-date sensitivity but exposure to foreign currencies isn't as risky as it's typically portrayed, especially over the long term. The reason is that some currencies such as the U.S. dollar tend to hold value in times of crisis, softening losses in Canadian dollars and smoothing out the investor experience. In 2008, for instance, the S&P 500 performed much better in Canadian dollars (-23.1%) than in U.S. dollars (-37%) due to a strengthening U.S. currency.
The diversification benefits of global investing haven't come from currency alone. As mentioned, the standard deviation of the MSCI World is 13.4% since 1970 but the TSX clocks in a few notches higher at 15.9%, resulting in better risk-adjusted returns for global equity and ultimately bringing to bear the differences between the broad global market and the concentrated Canadian market.
