Diversification for Canadian Investors

Because I follow the markets, I am occasionally asked by those I know of my opinion on how or where to invest. Invariably I deflect those questions since I know enough to know that I am not qualified to give that sort of personal and critical financial advice. Also, my track record is modestly good but far from stellar. I know enough to know I don't know enough; at least when I trade for myself I am somewhat comforted that my mistakes affect the fewest possible people.

A common and often very good investment strategy is diversification. The idea here is to spread your investment dollars across a broad range of sectors (mining, financial, technology) and investment classes (equities, fixed income) so that you reduce volatility. This protects you on the down side when one sector drops precipitously, such as the recent financial meltdown or more recent fall in commodities, even though it also limits your near-term gains on the upside. If you are not an active investor and simply want to invest and forget, diversification is your friend, with the caveat that there can never be certainty of positive returns.

One technique for diversification that many use is to buy index funds or cross-sector mutual funds. It's simple and seems to meet the criteria for the casual investor. However, if you're a Canadian investor you should perhaps think again.

The Canadian economy is not diversified and neither are broadly-based investment vehicles that focus solely on Canadian markets. Many of you are likely familiar with the cliche that Canadians are "haulers of wood and drawers of water", yet some fail to take that into account in their investment choices. The TSX Composite index, as a prime example, is heavily skewed toward commodities and raw materials. While the numbers do fluctuate wildly, one estimate has the current index almost 50% basic materials and 18% manufactured goods, which is almost the reverse of the far more diversified US markets. We are also prone to bizarre situations like in 2000 when Nortel itself was about one-third of the total Canadian market capitalization.

The message here is that if you do want diversification, and you want to stick with Canadian investments, you will have to be more active with your investment. I do not mean you have to pick stocks, but you should at least select sector-specific mutual funds and take the trouble to rebalance your holdings every one or two calendar quarters. By doing this you avoid the heavy weighting inherent in the broader Canadian markets. With the loosening of foreign holdings in RRSPs you can of course diversify to US and other markets, but keep in mind that when you do that you are engaging in currency speculation. Since the loonie's value does tend to reflect the domestic economy's strength, which remains raw materials, this can run counter to any diversification strategy.