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How much US dollar investment in your RRSP is too much?


How much US dollar investment in your RRSP is too much?

Contributed by: martingale

Investing 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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