Smart Diversification | WealthSmart

Smart Diversification


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Part 5 of the series: Rethink the Way You Invest.

I’m a very patriotic Canadian. Although I love to travel outside our borders, it’s always great returning to the true north, strong and free. During a trip to Europe five years ago, the Canadian flags on our backpacks attracted nothing but positive feedback about our great country. Having said that, I will try to tone it down and blend in a bit more on our next trip!

When it comes to investing though, I prefer global diversification. Don’t get me wrong. Even though Canada represents only 4% of the global stock markets, it comprises one-third of my own portfolio. That’s eight times what Canada represents in the world’s economy and, I believe, patriotic enough!

Our economy is relatively young and quite focused on a few dominant sectors, namely the Financial, Energy and Materials industries. We are woefully under-diversified in regards to Information Technology, Healthcare, Consumer Goods and Utilities. Consequently, our stock market tends to be more volatile over time when compared to the United States or Europe. We also miss out on the dynamics of the emerging markets.

Many Canadians concentrate their investing within these borders because of familiarity and because Canadian companies dominate our local news. They choose Canadian stocks and mutual funds—or use several brokers who, by default, often focus on Canadian stocks. Many of these investors may not consider their portfolios to be undiversified. Yet, from a global perspective, limiting one’s investment universe to a single stock market is a concentrated strategy with possible risk and return implications.

Let’s compare a portfolio of 100% Canadian stocks to a global portfolio diversified equally into 3 parts: Canadian stocks, US stocks, and International stocks. Over the past 48 years, The Canadian Stocks had a 9.25% compound rate of return versus 10.38% for the global portfolio. That’s not nearly as significant as the fact that the Canadian Stock portfolio was more volatile than the global one!

Diversification should not be defined by how many stocks or funds an investor owns—or how many brokers one uses. A diversified portfolio should include asset classes that are exposed to different risk factors throughout the world.

Investors typically use bonds to reduce the risk of Canadian equity portfolios. They are missing the benefits of global diversification. While adding fixed income to a portfolio will reduce risk, it will also reduce expected returns. Global diversification is a very efficient means of risk reduction. Once the equity portfolio is globally diversified, an investor may consider adding fixed income to further reduce the portfolio risk, given one’s risk preference and financial profile.

Most of us like the idea of travelling around the world. Let’s start with our investment portfolios!

Click here for Part 6: “Investment Costs Do Matter.”