Here’s a look at the benefits of geographic diversification for your portfolio
One key factor in successful investing—apart of course from picking good stocks (or ETFs that invest in those stocks)—is to diversify your portfolio.
Our main suggestion would be to make sure that your holdings are always well-balanced among most if not all of the five economic sectors—Manufacturing, Consumer, Utilities, Resources, and Finance.
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That way, you avoid overloading yourself with stocks that are about to slump simply because of industry conditions or changes in investor fashion.
By diversifying across the sectors, you also increase your chances of stumbling upon a market superstar—a stock that does two to three or more times better than the market average. These stocks come along every year. By nature, though, their appearance is unpredictable.
It’s also essential to diversify within each sector. For example, you shouldn’t let technology stocks dominate your Manufacturing holdings, nor let telecommunications or phone stocks dominate your Utilities holdings.
What about geographic diversification?
We’ve long said that most Canadian investors should hold the bulk of their portfolio in high-quality, dividend-paying Canadian stocks well balanced across the five sectors (or ETFs that hold those stocks).
We also feel that virtually all Canadian investors should have, say, 20% to 30% of their portfolios in U.S. stocks (many of which also offer you international exposure through their foreign operations).
Beyond that, top international stocks or ETFs can also add valuable diversification to your portfolio—through exposure to foreign businesses and to foreign currencies.
To demonstrate how geographical diversification can benefit investors, we examined the risks and returns of an ETF portfolio consisting of 50% Canadian equities, 30% U.S. equities, and with 20% in equities around the rest of the world. We then compared the risk and returns of this diversified portfolio with a broad Canada-only index.
Geographic diversification can cut risk and raise returns
Our results showed that the risk of the diversified portfolio was lower than the Canadian-only portfolio, while the returns were higher.
To test the risk, we used two parameters, namely the standard deviation of the monthly returns (which is a measure of volatility) as well as the maximum top-to-bottom loss (or maximum drawdown).
Over all time periods (5, 10, and 20 years), the volatility of the regionally diversified portfolio was lower. The maximum drawdown for the diversified portfolio was also lower.
The returns of the diversified portfolio were ahead of the Canadian-only portfolio over 5, 10, and 20-year periods (see graph above). Over the past decade, for example, the diversified portfolio added 150% while the Canadian-only portfolio gained 100%.
All this supports our advice on geographic diversification, whether you invest in stocks—or in stock ETFs.
How are you using geographic diversification? Leave a comment below.
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