The concept of investing globally may be explained by the old adage, "Don't put all your eggs in one basket." The idea is that by putting your eggs in several baskets — that is, by diversifying your investments beyond Canada – you may be able to create a more balanced investment portfolio.
"There is something called home-country bias," explains Al Emid, veteran financial journalist and co-author with Gavin Graham of Investing in Frontier Markets. "People are more comfortable putting their money into their home country. But there is an opportunity cost in ignoring other developed markets as well as emerging and frontier markets."
The Canadian market
Not that Canada hasn't provided investors with some very good returns over the years; it's just that the Canadian market is small on a global scale and limited in what it offers. The World Federation of Exchanges reported that its 58 regulated member-exchanges had a market capitalization of US$54,672 billion at the end of 2012. The TMX Group, which includes the Toronto Stock Exchange and the Canadian Venture Exchange, represented less than 4% of that.
And that's just one slice of the pie. More than 120 countries have stock exchanges, say researchers Todd Moss and Ross Thuotte in their recent paper Nowhere Left to Hide for the Centre for Global Development. Any way you look at it, Canada is a relatively small basket.
The Canadian marketplace is also limited in the opportunities it offers investors. Companies from three sectors – financials, energy and materials (which includes big mining companies) – make up more than 70% of the S&P/TSX composite index, a proxy for the Canadian market. (The index covers 95% of the equities market.) So, if you think technology stocks are the future, or that an aging population makes health care companies a good bet, there are few investment options available to you in Canada. Technology stocks make up a mere 1.65% of the index and health care, only 2.91%. That means that to take advantage of potential opportunities, you need to look outside Canada's borders.
The international market
"There are a number of excellent international companies headquartered in Europe or Japan," says Graham, a portfolio manager with a long and enviable track record. "In the U.S., Europe or Japan, you are getting things you can't get in Canada."
So, by investing globally, you are in a position to do two things: potentially increase returns by seeking out opportunities not available at home; and reduce risk. If your entire portfolio is invested in Canadian markets and oil and mining stocks go south, the overall market will feel the impact. (Remember, these two sectors make up almost 40% of the composite index.) Or, if an economic crisis sends Canadian markets into a tailspin, your financial well-being will be threatened. But if your eggs are in several baskets and trouble strikes, one egg may be smashed, but the others will be unharmed.
This is where the concept of correlation comes in. Markets are cyclical but, generally speaking, they don't all move together. Some, those with a "correlation co-efficient" of +1, move in lockstep: When one moves up or down, so does the other. Canada and the U.S. are generally an example of this. In fact, as the 2008 crisis demonstrated, the markets of all developed countries have become very interconnected and often move together.
Other markets, those with a correlation co-efficient of -1, move in the opposite direction from one another: If one goes up, the other goes down, and vice versa. Some markets, of course, don't correlate at all and that is what Emid and Graham see as the advantage of frontier markets, a subset of emerging markets. There are about 40 countries – including Vietnam, Kenya, Nigeria and United Arab Emirates – that are considered frontier markets by established indices, which are where emerging markets such as China and India were in their economic development 10-15 years ago.
"Frontier markets are not correlated with either developed or emerging markets," says Graham. "Because they are not correlated, they reduce the overall volatility of your portfolio."
So, how much of your portfolio should you invest internationally? Graham suggests 15% to 25%, with frontier markets representing 5% to 10% of your international exposure (.75% to 2.5% of your total portfolio). But it all depends on your age and stage of life. If you are younger and can leave your money to grow, you might be at the top end of the range. If you are retired or nearing retirement and need to draw down on your investments, you'll be at the lower end of the range. And what are the easiest ways to make those investments? One solution is by investing in mutual funds or, in the case of developed and emerging markets, exchange-traded funds (ETFs). That way, you can put the stock and country selection in the hands of professionals.