I recently conducted the following interview with the author of The Smartest Investment Book You’ll Ever Read (read review):

Can you give us a little bit of personal background on how you became convinced that it is extremely difficult to beat the market consistently?

For many years, I represented investors who lost a significant portion of their assets due to broker misconduct. It struck me as really odd that these “investment professionals” could be wrong so often. I started doing research, which resulted in my first book, Does Your Broker Owe You Money? The research was so overwhelming that it left absolutely no doubt in my mind that trying to “beat the market” is a zero sum game.

I was already convinced of the merits of “smart” investing before I read your book. Why do you think that, despite overwhelming evidence, average investors are still not heeding the message?

A combination of factors contributes to this anomaly. Among the most prominent ones are: cognitive dissonance, the thrill of the chase and very aggressive (and misleading) advertising by the securities industry.

You recommend that Canadian investors allocate just 10% of their equity portion to domestic equities. Can you explain why in a little bit more detail?

This equates to the portion of the Canadian Stock Market as a percentage of the world stock market. We’re trying to develop globally diversified portfolios, and too many people tend to believe that their own “domestic” markets are more “certain” or safe than other markets (which is not really true). Therefore, we were trying to develop portfolios that will ultimately give investors global diversification that is consistent with the overall capitalization of their markets.

Here is the official market cap breakdown at year-end 2006 [For brevity, I have dropped the table which lists Canada at 2.89% of global equities]. As you can see, the Canadian market is roughly 3% of world market cap. We are actually recommending an over-exposure relative to the world cap weights simply because people do feel more comfortable with the securities of domestic companies. Our portfolios take that into consideration, but we think more than 10% exposure is too out of line.

The TSX Composite is concentrated in just two sectors – financials and resources – and most Canadian investors already own a bank or two. What is your opinion on getting exposure to Canadian equities by investing in a handful of stocks?

Since #3 above assumes that only about 10% of the investor’s portfolio is invested in Canadian equities, they’re not really getting any “over-exposure” to financials or resources. The problem with owning a handful of stocks instead of a diversified “market” is that you start to add an additional element of risk. History is full of “rock-solid” companies that quickly went belly-up or lost a large portion of their value (Worldcom, Enron, Cisco, etc.). There have been some studies done recently that have shown that the volatility of individual stocks has increased in the last decade (most likely due to day-trading) but that even though individual stocks are more risky, markets as a whole have NOT become more risky. So, why take the additional risk of holding a few stocks and not achieving market returns if one or two of those stocks suddenly lose value when the market as a whole is remaining constant? As is the case with active management, the added risk probably won’t equate to greater results.