International diversification: Does it belong in your investment portfolio?
Diversification is a cornerstone of a sound investment strategy. At its simplest, the concept is often likened to the adage “Don’t put all your eggs in one basket”. Investing in different types of assets (like stock, bonds, real estate, different industries, and geographic regions helps to reduce the overall risk of an investment portfolio. Most Canadian investors use investment funds to diversify their portfolios and mitigate investment risks. However, a June 2024 study by Vanguard highlighted a common bias among Canadian investors: a preference for domestic stocks, known as home bias.
Investing in a market that feels familiar is not a trend unique to Canada. Home bias is a global phenomenon. But the overreliance on investments from a single country can be limiting. Home bias can expose a portfolio to assets that are dependent on common factors — including the political, economical, and technological stability of the country. This is where diversifying internationally can be beneficial.
October is Investor Education Month, the perfect time to reassess your strategies and deepen your understanding of fundamental investment concepts like diversification. Before investing beyond Canada, ensure you learn and understand all your options and consider how diversification can benefit your investment portfolio.
Canadian market vs. the global market
The Canadian market is known for its stability, resilience, and strong regulatory oversight. However, investing exclusively in Canada can come with limitations. The Canadian stock market is relatively small. According to a 2023 global equity market study by the Securities Industry and Financial Markets Association (SIFMA), Canada accounted for only 2.7 per cent of world capital markets. This means that over 97 per cent of the world’s investment opportunities are located outside Canadian borders. Investing in international markets can provide Canadian investors with an opportunity to benefit from the size and scale of the global economy.
Canada’s market concentration
Canada is the ninth-largest economy in the world, with key industries like manufacturing of products such as paper, technology and automobiles and natural resources including mining, oil and gas and agriculture playing a critical role in the country’s economy. This industrial focus is strongly reflected in Canada’s capital market. As of August 2024, almost half of the S&P TSX Composite Index — which includes the largest companies listed on Canada’s primary stock exchange — is mainly comprised of two sectors: financial institutions, such as banks, and energy, including oil and gas resources. Similarly, the Canadian Securities Exchange Composite Index is dominated by life sciences, followed by mining.
Due to this concentration in Canadian public equity markets, investors who invest solely in their home country may miss out on opportunities in sectors that are growing more significantly in other countries. By diversifying internationally, Canadian investors can gain exposure to other sectors that are driving global economic growth and innovation.
The rise of emerging markets
Many Canadian companies have a strong tradition of paying consistent dividends, which may appeal to investors seeking a steady income. However, the capital markets in some developing nations, commonly referred to as emerging markets, often offer attractive opportunities due to their rapid economic growth and potential for higher returns. In fact, a Goldman Sachs report suggests that these emerging markets are projected to overtake the U.S. by 2030. In a June 2024 paper, Franklin Templeton highlighted that emerging economies have become more resilient and less vulnerable to fluctuations. It is important to remember that emerging markets do carry increased investment risks — including political instability, regulatory uncertainty, lack of liquidity and currency volatility. Before investing in these markets, consider talking to a registered financial advisor who understands your risk tolerance, your investment goals and time horizon.
Tactics to diversify your investment portfolio
- Explore global or international market funds: Globally or internationally focused investment funds, including ETFs, can provide access to a wide range of global securities. This enables you to easily diversify your investment portfolio across the global economy.
- Consider a long-term perspective: A long-term approach aligns with the fundamental principle of diversification as different markets tend to outperform others at different times. By maintaining a diversified portfolio, an investor can potentially benefit from growth opportunities across various regions and economic cycles.
- Rebalance your portfolio regularly: As market conditions change, it’s important to rebalance your portfolio to ensure that your asset allocation aligns with your risk profile and investment goals.
Diversification is a powerful tool for managing risk and potentially enhancing returns. While investing in Canada offers home-country advantages, such as familiarity with local companies and favourable tax treatment, investing across diverse geographies can help build a more resilient portfolio that is better equipped to weather market fluctuations. By taking a long-term view and exploring opportunities in different geographic regions, investors can embrace a holistic approach to diversification and potentially reap its rewards.