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Most investors understand the importance of building a diversified portfolio — one that includes stocks for growth potential, bonds for stable returns, and cash for security. But that's just the first step.
Having some exposure to global markets can help to reduce risk and increase potential returns — two of the main reasons for diversifying an investment portfolio.
To find out more about why you should hold foreign content, click through the links below.
Size matters
Holding investments in just one small corner of the world means that your portfolio is tied to that market's performance. When the trend is up — as it has been in Canada in the past few years or so — that's great. But, as history has shown, market leadership tends to change from one year to the next.
The most effective way to protect against declines in Canada's market is to diversify into other geographic areas. After all, Canada represents just a small portion of the world's investment opportunities — most estimates put the number between 2% and 3%.
Some of the world's largest and fastest-growing companies are based outside our borders. In addition, certain sectors have their largest centres outside Canada — high-tech in the U.S., consumer products in Europe, and electronics in Asia.
South of the border
Many Canadian investors diversify their portfolios with U.S. stocks and U.S.-based mutual funds. While U.S. exposure certainly has merit, it is important to remember that the U.S. and Canadian markets are highly correlated. In other words, they often move in the same direction at the same time.
For truly effective diversification, consider investments in markets that aren't highly correlated with Canada's. Markets outside North America — in Europe, Asia, and Japan, for example — are less correlated with U.S. stocks than are Canadian stocks. This can help to reduce the overall risk in your portfolio.
Currencies fluctuate
As the past few years have shown, fluctuating currencies are another reason to look beyond the U.S. for diversification. The loonie has been soaring, relative to the U.S. dollar. So, even though U.S. markets performed well in 2003, for example, some of those gains were eaten away when converted back into Canadian dollars.
By holding investments based on a variety of currencies, you reduce the negative impact that a decline in any one currency can have on your portfolio.
Going global
So diversifying your portfolio internationally looks like a sound strategy. But how do you actually go global?
The fund route. For most investors, the easiest and most convenient way to add some international flavour is with professionally managed mutual funds. The Canadian market offers hundreds of mutual funds that invest outside of Canada. Global mutual funds can provide your portfolio with foreign exposure, growth potential, and the diversification appropriate for conservative and more aggressive investors.
Do it yourself. Many companies that are listed on Canadian or U.S. exchanges have sizeable interests outside of North America. You'll need to do some research into the company's activities to find out how much foreign activity is involved and where it's located.
Self-directed investors can purchase foreign shares directly from foreign exchanges. With U.S. shares, the process is straightforward and the shares can be held in a Canadian account. For exchanges in other countries, however, you may need to open an account with a foreign brokerage. Bear in mind that getting information on foreign companies and dealing with foreign trading rules and regulations can be cumbersome and expensive.
An easier way to purchase foreign shares is to buy companies that are available as American Depositary Receipts. These are shares of non-North American companies that are held on deposit in the U.S. and trade on a U.S. exchange in U.S. dollars.
Exchange-traded funds (ETFs) are another way for self-directed investors to add global diversification. ETFs are index-based investments that offer exposure to a basket of stocks from a number of regions around the world.
Speak to your financial advisor or your broker about strategies to enhance the global reach of your portfolio.
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