Proper diversification means investing abroad

You wouldn't limit your diet to only one food group, knowing that a proper balance of different foods is one of the keys to good physical health. Many Canadian investors, however, tend to only look at one geographic region when making investment decisions, which can limit the long-term health of their portfolios. By investing a large percentage of assets in Canadian companies, investors leave behind over 96 per cent of the global opportunities that exist outside our borders.

Question:
Why are financial advisors recommending global investments when Canada's economy has been firing on all cylinders over the past few years?

Answer:
Canada's economy has been on a tremendous run, with its key sectors – resources and financial services – showing no signs of letting up. The downside to this growth is that a number of Canadian stocks are today selling at a significant premium, with some companies on the Toronto Stock Exchange (TSX) trading at over 20 times earnings. In comparison, the rising Canadian dollar has resulted in global companies that are 10 to 30 per cent cheaper than they were just a few years ago1, amounting to some of the best investment opportunities available. Investing in other countries also helps you better diversify your portfolio, with access to sectors and companies not available in Canada.

DIVERSIFICATION: A TRIED AND TRUE INVESTMENT STRATEGY
It's no secret that proper diversification can be an effective long-term investment strategy for achieving better returns and may lower volatility within a portfolio. While many investors already diversify by asset class and investment style, the same logic applies to investing across geographic regions. Focusing on Canada's relatively small market restricts Canadians from many of the attractive opportunities that exist in other countries.

Consider this: Canada's economy, which has been so strong over the past few years as a result of soaring resource prices and low inflation, grew three per cent in 2005 and, if the current economic environment persists, our economy is expected to grow another 3.2 per cent in 2006. Although this is considered good economic growth compared to many other industrialized nations, it is also considerably lower than the Chinese and Malaysian economies, which grew at rates of 9.3 percent and 5.3 per cent, respectively, in 2005.

The economic growth experienced by other countries has also been reflected in the stock prices of many of their biggest companies. While the Canadian TSE Index recorded an impressive 21.9 per cent one-year return in 2005, the German DAX Index rose 27.1 per cent and the Nikkei 225 Index in Japan was up 40.2 per cent. With the prospect of further significant growth in 2006 and 20072, these countries – and many others – represent tremendous investment opportunities that are missed by individuals who invest the majority of their portfolios in Canadian companies.

THE BENEFITS OF INVESTING ABROAD
In 2005, the Canadian government dropped its foreign content restrictions for Registered Retirement Savings Plans (RRSPs), making it easier than ever to increase your portfolio weighting outside of Canada. If you are like many Canadians, however, you still maintain a large percentage of your investments in Canadian companies. Diversifying more of your investment capital into global opportunities can provide a number of very important benefits for the long-term success of your investment portfolio. Three key points to consider when increasing your portfolio weighting outside Canada are: risk versus return, increased diversification among sectors, and access to some of the strongest companies in the world.

RISK VERSUS RETURN
There is often a perception that investing in other countries can expose a person to unwanted risk in the form of political or economic upheaval, corporate governance issues, or natural disasters. Although not entirely unfounded, there are a number of strong arguments against this thinking that should be considered.

The first argument is that there is an inherent risk to a heavy investment weighting in any one country. Although Canada's economy has been growing steadily over the past few years, with low inflation and interest rates and high resource prices driving our markets, a change in this economic environment could put pressure on Canadian stock markets. By diversifying among a number of geographic regions, the risk of dizzying swings in the value of your portfolio from negative pressure on Canadian markets can be significantly reduced, as good performance by other regions may help offset any potential market underperformance in Canada. Many Canadian investors also view foreign investment with a cautious eye due to the perception that foreign investment automatically means higher volatility. The opposite has historically been the case, with a recent study by Benefits Canada titled Capital Accumulation Plans stating, “Based on three-year rolling standard deviations of the S&P/TSX Composite Index and MSCI World Index over the past 30 years, there have been only two instances when Canada was less volatile than the world.”3

INCREASED DIVERSIFICATION AMONG SECTORS
One of the keys to achieving a properly diversified portfolio is to spread your investment dollars across different sectors. That way, if one or more of the sectors you're invested in underperforms, you have money invested in other sectors to help balance out the weak performers. Canada's economy – while well over the past few years – is very concentrated in just a few sectors. It's estimated that our market is weighted at approximately 71 per cent in resources and financial services. This means maintaining a heavy portfolio weighting in Canada can severely limit your ability to invest in sectors that may be tremendous performers over the next few years. Canadian markets provide somewhat limited opportunities in sectors such as technology, consumer staples, automotive and pharmaceuticals.

WHAT IS A SECTOR?
Sectors are industries or areas of an economy. A sector will include a number of companies that produce similar types of products or services. Examples of sectors include forestry, automotive, technology, health care, pharmaceutical and oil & gas. Although resources and financial services have performed well compared to many other sectors over the past five years, the impact of any weaker performances from these sectors merits diversification into sectors more readily available outside of Canada.

“We know that resources, commodities and financial services companies have been great performers over the past few years, and we certainly wouldn't advocate abandoning these sectors completely,” says Donald Guloien, Chairman and Chief Executive Officer of MFC Global Investment Management. “There is, however, a strong argument for diversifying assets into other sectors in order to help balance any potential weakness that occurs in the more traditional Canadian sectors over the coming years.”

ACCESS TO SOME OF THE STRONGEST COMPANIES IN THE WORLD
Global diversification also offers access to some of the world's top-performing companies. “Canadians who keep the majority of their investments in Canada should consider diversifying their portfolios abroad,” says Guloien. “By limiting yourself to Canada, you're overlooking companies like Toyota, Adidas, Nokia, Esprit and Royal Dutch Shell, which don't trade in the Canadian market. Global investing can be a great way to maintain or enhance your investment performance, while lowering portfolio volatility.”

TAKE ACTION - SPEAK WITH YOUR ADVISOR
The first step to building a globally diversified portfolio is to speak to a financial advisor to determine the most appropriate allocation of your investments based on your long-term investment objectives and risk profile. Your financial advisor can help you build a portfolio of investments that are well diversified among different asset classes, investment styles and geographic regions to suit your unique investor profile. By following a disciplined investment plan and re-evaluating this plan every year to ensure it stays in line with your changing circumstances, you will be well positioned for long-term success with fewer sleepless nights.

1 Source: Benefits Canada, Capital Accumulation Plans.
2 Source: MFC Global Investment Management, Global Economic Views, February 2006.
3 Source: Benefits Canada, Capital Accumulation Plans.