Contributed by: martingale
 A reader recently wrote asking whether the allocation of ETF's I recommended in RRSP Foreign Content Rules Scrapped overweighted
investment in the United States--wondering in particular if perhaps there is risk that the US dollar might be devalued soon. How much foreign content should you hold in a self-directed RRSP?
Certainly, the US economy has some issues: Overall the United
States is spending 6% more every year than it's earning, and as
a result, America is going deeper and deeper into debt. This
situation has been termed "unsustainable" by people such as
Paul Volker, a former chairman of the U.S. Federal Reserve.
On the other hand,the US economy is still the world's strongest. It
eclipses Japan and outpaces Europe. China, despite its radical
transformation into a successful capitalist economy, and despite
all the hype, is still a bit player, relative to Japan, Europe, or the
United States. At the same time there are no guarantees about the
Canadian dollar. Our economy, while strong now, is not without its
intrinsic weaknesses, politically and economically. Were Quebec to
separate our dollar could tank; and our dollar and economy are
also strongly influenced by swings in commodity prices.
The difficulty in predicting the future is that it hasn't happened
yet. No one knows what will happen to the U.S. dollar. No one
knows what will happen to the Canadian dollar. If the U.S.
dollar is devalued by a financial crisis, that crisis could easily
spill over into Canada and take down our currency at the same
time.
Further, in these currency debates an often overlooked risk is the
risk of inflation. If Canada, for some reason, goes through a
period of massive inflation then those people who have most of their
investments in Canadian dollars will find their spending power
significantly eroded compared to others who had more of their
investments denominated in a foreign currency.You really ought to
have some foreign investments in order to protect yourself from the risk
that the Canadian economy itself will go through a difficult time.
What I'm trying to get across, in a round about way, is that it's
somewhat foolish to base an investment strategy on these macro
economic questions that nobody can answer; and generally the
issue is more much complex than the simple analyses printed
in the financial press convey. These macro economic questions
are tough to answer, and honestly, are generally far less important
to your portfolio than micro economic issues.
All other things being equal you should invest your money in each
of the worlds markets roughly in proportion to the size of that market.
This is the same thinking that says you should invest in each stock
within a market in proportion to its market capitalization--the standard
indexing strategy, such as you are following if you invest in the
S&P-500 or the TSX index. The overall global market's allocation of
funds to each country represents the consensus opinion of all
investors on the planet--not a bad starting point.
However, the financial situation of many of those investors is different
than your particular situation, and as I mentioned above, the micro
economic issues surrounding your own life likely outweigh any of
the macro economic questions. A much more important question here is
what is your personal situation? Will your expenses mostly be in
Canadian dollars? Are you planning to spend part of your retirement
in Florida? How many years of work do you have left, and does your
job already over-expose you to Canadian dollar risks?
If you are retired (or soon will be) and most of your expenses have
to be paid in Canadian dollars then you should increase your Canadian
holdings to eliminate the volatility of random currency swings. Matching
your investments to your expenses is a smart idea. However, do keep
some foreign investments as a hedge against inflation!
If you still have many income earning years ahead of you, but your
job prospects depend on the Canadian economy (most working people's
do) then you might want to
avoid Canadian investments lest your job and your savings are both lost in the same Canadian recession.
There is nothing worse than needing your savings at just the moment
when they've hit rock bottom.
As a general rule of thumb, I would say you should have 20-60%
of your money in the United States and 10-30% in the rest of the
developed world, 5-15% in emerging markets, and 5-60% in
Canadian investments. I've left a lot of room for you to adjust these
values to your personal financial situation, but clearly I think very
little of the notion that just 30% of your investments should be
foreign. (Note: I am talking RRSP here; outside of an RRSP there
are tax issues that can change everything!)
You should settle on an allocation which best reflects your current situation.
In deciding this for yourself consider how many more years you will depend
on the Canadian economy for your livelihood, and how many years until you
will have retirement expenses that must be payed
in Canadian dollars.
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