As I am self-employed and paid in dividends rather than salary, the majority of my investments are in non-registered accounts. I’ve been struggling with the general question of expected returns vs. diversification on a couple of fronts. First, it is generally accepted and understandable that Canadian equities should be expected to outperform foreign equities on an after-tax basis due to the dividend tax credit. Therefore, it makes sense to have *some* over-weighting of Canadian equities. By doing so, you are adding geographical and sector concentration aka reducing diversification, so can expect higher volatility. Currency exchange risk also adds to that volatility even though it shouldn’t affect very long term expectation. In many cases, currency exchange costs would also have to be factored in, although in my personal situation they are not significant given the nature of my business. So for me, the question boils down to how much added volatility I am willing to accept in return for the added expected return of the Canadian dividends. (A tricky question to answer without being able to exactly quantify the volatility involved!)

Thinking about this though, I realized it basically mirrors the general equity/fixed income split issue. I currently have a 75/25 equity/income split, where the fixed income is split between preferreds and short term bonds (again trading off between safety/diversification and expected after-tax return). But if I’m contemplating over-weighting Canada in order to increase my expected return at the cost of higher volatility, what am I doing holding fixed income at all? Couldn’t I just as easily move to 100% equity, essentially making the same tradeoff, except with a larger boost in expected return?

Put another way, in a non-registered account, does it make any sense to start over-weighting Canada at all, while still holding fixed income investments? Even if the fixed income is preferred shares, you could expect to gain more on average by switching that into diversified equities than by over-weighting your equities in Canada. (On the other hand, perhaps the increase in volatility is greater with this change as well.. I don’t even know how to begin to quantify that.)

Finally, on the far end of the spectrum is the approach of over-weighting small caps. As above, small caps have theoretically higher expected returns but greater volatility. I don’t have exact numbers here, but I expect that the increase in volatility is greater, and the expected increase in return is lesser, than either of the options above. So then if this line of thinking makes sense, even if all you care about is expected return, it isn’t logical to start adding focus on small-cap stocks until you already have a 100% equity, largely Canadian portfolio. (And likely not even then, since then you would be sacrificing Canadian dividends to do so.)

What do you think? Again, all this only applies to non-registered accounts, and basically consists of my musings and assumptions. I haven’t thought about this over a long period of time or done any definitive research. And I’m certainly not suggesting just going 100% Canadian equities in registered accounts; just that if a person wants to trade added volatility for added expectation, the various methods for doing so (more equities vs fixed income, more Canadian equities, more small-cap) should be prioritized based on which method increases expectation the most and volatility the least. Hopefully someone can definitively tell me which that is!

http://seekingalpha.com/article/338231-the-winning-trade-in-high-yield-corporate-bonds

It’s an interesting article and comparison. thanks again…