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Spreading your eggs across many baskets: Why drop in oil should be a lesson to diversify

Eggs-in-the-basketThe rate at which energy prices have fallen has caught many by surprise. Oil prices alone are down more than 50% since June 2014. While the drop in oil has lowered the gas bills for many Canadians, there are other impacts affecting households throughout the country. In Alberta for example, there have been layoffs in energy-related jobs and a housing market that has reversed course and is now falling in value. What’s more is the very real impact to Canadian investors.

Energy’s role in the Canadian economy
Canada ranks as one the world’s five largest energy producers1 with energy being Canada’s top export. In fact, energy represents 26.1% of the dollar value of exports and the equivalent of 13.4% of the GDP2. When it comes to jobs, energy represents about 5% of direct/indirect employment in Canada3, and energy-related jobs tend to pay higher than the average salary. Some areas of the country are much more heavily dependent on the industry – Alberta, for example – and the employment impacts are much more pronounced.

While the drop in energy prices on employment are obvious, less understood are the wide-ranging ramifications to other sectors, including finance. Banks may find themselves burdened with loans from failing (or underwater) energy producers. And as employment in the energy industry declines, consumer loans (e.g., credit cards, mortgages, and vehicles) may take a hit, further affecting Canadian banks’ balance sheets.

The one-two punch on energy and finance is already obvious in the trajectory of the overall stock market. In the last six months of 2014, the S&P/TSX Capped Energy Index returned -23% and the S&P/TSX Capped Financials Index returned 1%.

Home-Bias Investing: Buying what we know
Real estate agents have long touted, “Location, location, location!” A same adage is true when it comes to investment portfolios. The stock market can be unpredictable, and it is important to establish a diverse, global investment strategy that tempers potential losses in a bear market. Unfortunately, many Canadian investors fail to act in their own best interest when it comes to developing and maintaining their investment portfolios. Many investors tend to overweight their portfolios with Canadian stocks, funds and ETFs. This lack of a global approach to investing can lead to volatility and reduced returns – precisely the opposite of what investors expect when “buying what they know.” Further, it is important to remember that the Canadian economy only accounts for approximately 3% of the world economy as measured by its GDP. Investing solely in Canadian companies limits U.S. and global investment opportunities. For example, as of the end of 2014, the U.S. S&P 500 had a cumulative five-year return of more than 67% while the Canadian S&P TSX had only generated an approximate return of 24% over that same time period. It is important to remember that Canada’s two biggest sectors – Energy and Banking – represent over 60% of the Canadian S&P TSX index. Therefore, owners of mutual funds or ETFs that invest solely in the broad-based Canadian market, by default, receive substantial exposure to the oil and gas industry.

With the energy sector so prominently embedded in the economy and (often) in investors’ work lives, Canadians tend to invest a disproportionate amount of their retirement funds back into energy company stocks or funds. Those who are employed directly by oil and gas companies should explore investing their savings in areas of the market that are outside of the energy sector. For those individuals that receive stock options and shares from their companies as part of their compensation packages, a strategy should be put forth to divest themselves from their concentrated stock positions.

A Diverse Approach
Diversification is nothing new, though many are at a loss for how to actually attain it. Below are some ways in which Canadian investors can protect their assets and help reduce risk.

  • Look for variety: Diversification does not mean having a lot of investments. It means having a lot of different kinds of investments. Consider different asset classes that diversify by geography (Canada, U.S. and International), style (growth vs. value investing) and capitalization (small cap, mid cap and large cap investing). Each asset class will perform differently and can help to manage overall risk.
  • Spread your eggs across several industry baskets: Don’t put all of your money into one sector, whether it be tech, life sciences, or energy. This strategy helps protect your financial plans from derailment when one market is hit.
  • Understand your tolerance for risk – and reward: Risk and reward go hand-in-hand. Once you determine your own risk tolerance, this information will help you to build the right target mix for your investments. This investment mix will not only manage your risk-reward tolerance but can potentially improve returns at your level of risk.
  • Don’t set it and forget it: It’s important to review your accounts on a quarterly basis to make sure that investments aren’t too heavily weighted in one asset class or another. If needed, rebalance to ensure that your investment mix is aligned with your financial goals and strategy.

The optimal strategy is one that is prudent, agile and responsive, and it will be best equipped to offset risk when the market takes a sudden turn. Or as sports enthusiasts might say, a good offense is the best defense.

1 Source: U.S. Energy Information Administration
2 Source: Department of Numbers and Macleans
3 Source: Natural Resources Canada (NRCAN)

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