My first three columns have covered a lot of ground, but there is more to cover. The stock market presents endless learning opportunities, but we want to keep our approach simple and effective because we have our farms to run and our lives to live. The first column covered the advantages of a TFSA; the second instalment discussed how to start a small portfolio of up to $15,000. The third one covered the most fundamental investment principle, “The Rule of 72,” which highlighted how money compounds over time.
This column will take portfolio construction a little further to discuss the importance of international diversification with sectors that are almost absent in the Canadian market. When I was growing up almost a half century ago, the Canadian economy was described by the term “hewers of wood and drawers of water.” The discussion at that time was the need to diversify our economy away from basic resources, and yet here we are 50 years later with the same debate raging on.
Our economy remains highly dependent on basic materials. The three biggest sectors in the Canadian market are financials, representing 35 per cent of the market, with energy coming in at about 20 per cent and materials at about 12 per cent. Energy and materials are much smaller than five years ago, not because our economy has diversified, but because they have performed so poorly through the 2014 to 2016 commodity collapse. This poorly diversified economy is a key reason to diversify our stock holdings outside of Canada.
Other important reasons to diversify out of the country are currency diversification and the ability to own world class companies outside the financial and resource sectors. Most of our physical assets are invested in Canada. Stocks represent a very simple way to own assets outside of our home country. International diversification will also stabilize portfolio performance as we look to build a portfolio that requires little maintenance, one that does well in up markets and is resilient during downturns.
The taxing details
Two important considerations with foreign stocks are currency conversion and dividend withholding taxes. Look for a financial institution that allows both U.S. and Canadian currency TFSAs. With small accounts it may not be necessary, but as your account grows it is better to avoid paying conversion costs every time a dividend is paid or you buy and sell a foreign stock. With a U.S. dollar-based account, you only pay the conversion cost upon depositing and eventually withdrawing the money.
It isn’t an ideal time to convert money to U.S. dollars, with current exchange rates, but probably a necessary evil if you’re just starting out. I started investing in foreign companies, way back in the 1990’s and remember converting currency at a punitive $0.63 level. The experience was instrumental when our dollar reached relative parity from about 2005 to 2014. I spent that decade almost entirely focused on foreign investments, thinking our dollar at par was not situation normal. During that time frame I built our portfolios to about 65 per cent foreign which is very unusual for a Canadian investor, as most investors exhibit home country bias. This heavy foreign exposure served me well during the commodity collapse that severely affected the Canadian market.
Dividend withholding taxes are a smaller consideration. Foreign countries tax dividends of foreign investors at varying rates. The U.S. is 15 per cent, the U.K. is zero for Canadians, but some countries are as high as 35 per cent. There is a tax treaty such that Canadians don’t pay U.S. withholding taxes in retirement accounts, but that doesn’t apply to TFSAs or RESPs. Thus our RRSP is built on Canada and U.S., and our TFSA on Canada and U.K., completely avoiding withholding taxes, a good thing unless you like taxes! If just starting a TFSA, our current construction project, I wouldn’t worry about this nuance yet. Just focus on building the strongest edifice possible.
My next instalment will continue the effort to build out a prospective TFSA portfolio with actual stock suggestions for up to $115,000, the current maximum contribution for two people. I felt it was important for readers to understand the groundwork before construction commences.