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Why Invest Internationally?

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Diversification is the most important concept in investing, but also perhaps the least exciting. If anyone knew for sure exactly which one company or country would have the highest return in the coming year, there would be no reason to hold anything else. But while being able to predict markets with any certainty sounds great in theory, in practice nobody has been able to consistently outsmart the market. So what do you do if you can’t know for sure if Pepsi or Coke, or the US or Canada will be the best performer in the coming year? You diversify. This is especially important when it comes to financial planning.

While we may plan to retire in one country or have our peak earnings years in another, having broad-based global diversification can help you over the long run, even though in any give year or time period it can feel like it’s not benefiting you.

Stock Market Returns 2003-2006Let’s take an example of a Canadian investor who had a CAD account and was watching returns in the early 2000s. Between the start of 2003 and the end of 2006, the Canadian market far outpaced the US. You can see from the chart on the left that the annualized returns (in CAD) for Canadian markets was nearly triple the returns for US markets over that period.

Besides Emerging Markets, it would have been hard to see much reason to allocate any investments outside of Canada. And in fact, that’s much of what the Canadian and US investing media was telling you at the time- dump your US stocks, and buy Canadian and Emerging Markets! Yet moving to those markets solely and out of the US and International Developed markets would have been particularly painful shortly after in 2008, when  Canadian and Emerging Markets holdings would have underperformed compared to US markets, when viewed in CAD.

Stock Market Returns 2015-2017More recently, if we look at 2015-2017, Canada has delivered just half the performance of the US on an annualized basis, and well below the returns experienced in  International Developed and Emerging Markets.

As we can see on the chart below, the order of returns by region each year is essentially random. Trying to guess in advance each year which country or market segment will outperform will likely lead to simply buying what’s been hot in the last year and will often result in  disappointment. One area might do well for a number of years, as Emerging Markets did in the early 2000s, only to fall hard in 2008. US stocks did much better than Canadian stocks for 6 of the previous 7 calendar years, but underperformed significantly in 2016, and have experienced steeper declines this October.

Returns by Region
Diversification blog chart
*2018 YTD is Jan 1 – Oct 27

Instead of guessing which country or region is going to outperform next, astute investors can realize many benefits by spreading their assets across the group of global stocks. Doing so  allows you to capture the returns of whichever market is doing best in that time period, and ensures you’re never exposed to just one market or currency. As you can see on the chart, a blended exposure to the different regions means you can reduce your year to year volatility, and this is before the introduction of bonds or other asset classes that may move differently than stocks.

Over the last 15+ years, each region we looked at had strongly positive returns. Standard deviation measures how much those investments went up or down over the years, with  Emerging Markets being the most volatile. The Sharpe Ratio measures how efficient each investment was by comparing the magnitude of the returns  to the amount of volatility experienced. US stocks looked pretty good during this time period, but they don’t beat the blend when it comes to reward per unit of risk.

US stocks 15years

Looking back to the chart of annual returns above, we can’t know what region will have the strongest returns over the coming week, month or year. Yet, when we look at the blended result, which made no predictions at all but simply followed a long-term asset allocation between the four regions, we saw the lowest volatility and a healthy return , resulting in the highest Sharpe ratio.  This indicates that the blended portfolio is a  more efficient stock allocation than holding any one region individually. This blog looked at these regions from the Canadian Dollar point of view, but the results and theory are similar from the US Dollar perspective.

The downside of diversification is that you will never be the best performer. There will always be some particular stock or area of the market that will do better than the whole of your portfolio. But by having a globally diversified portfolio, you’re likely going to be capturing some of those gains. At some points, like 2008 or recently in 2018, all markets may see losses, however diversification ensures that you’re not taking unnecessary risk by having all of your exposure in any one company, sector, or country.

Thinking back to the financial plan that is crucial to the ability to meet long term goals, the long-term growth rates assumed are already factoring in ups and downs along the way. Nowhere in a prudent investment plan is the need to try and predict or out guess markets, but key to the plan is being able to capture those market rates of return wherever and whenever they do occur.

Source: Morningstar Direct 2018. Canada returns represented by S&P/TSX 60 TR CAD, US returns represented by S&P 500 TR CAD, International Developed represented by MSCI EAFE NR CAD, Emerging Markets represented by MSCI EM GR CAD. Blended mix represents 33% in Canada, 33% in US, 23% in Intl Developed and 10% in Emerging Markets, rebalanced annually. Indexes are unmanaged baskets of securities that are not available for direct investment by investors. Index performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. All investments involve risk, including the loss of principal and cannot be guaranteed against loss by a bank, custodian, or any other financial institution

Stock Market Volatility Is Nothing New

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market volatility

It’s common to hear about the long-term investment averages that we’ve all become accustomed to. Conventional wisdom says that over the long run stocks should earn something like 10% per year. And in that regard, the conventional wisdom is actually pretty good. Over the last 30 years through the end of 2017, the annualized return on the S&P 500 was 10.7%, and 9.0% on the S&P/TSX 60. Given great average annual returns on both markets, financial planning should be a piece of cake right?

Ah, but we know we don’t get that 10% every single year, right? It’s not like a bank savings account that pays out a steady interest stream every month. Some years are better, others are worse. This variability gives rise to measures such as standard deviation, a calculation that tries to paint a picture of how much volatility you will experience in an average year. For the two indexes, the standard deviations have been extremely close over that same 30-year time period; 14.0% on the S&P 500, and 14.1% for the S&P/TSX 60.

That means that for US stocks, in about two thirds of the years, we should experience a return of somewhere between -3% and +25%, if history is a good predictor of the future. In Canada that would mean a range of -5% to +23%.

Those seem like reasonable ranges for most years, however we know it’s the years that fall outside of those ranges that we tend to remember. When we look back on returns its easy to remember the boom times of the late 90s, for example 1996 when US stocks gained 23% and Canadian stocks were up 32%. It’s also impossible to forget some of the bad times, like 2008 when US stocks dropped 37% and Canadian stocks fell by 31%.

Yet what’s often lost in these long-term averages and outlier events to the good or bad side, is that year to year we actually see much more variation than you might think by just looking at the end of year numbers. Going back over that same 30 year period, the average intra year decline seen in both the US and Canada was about 13%. That means that on average, at some point during a calendar year, the stock market was in a correction phase- a decline of more than 10% from its high for the year. The chart below show the annual gains since 1988 for both the S&P 500 and the S&P/TSX 60 in blue and red bars, respectively. Below, the line graph shows the largest intra year decline for each year.

Annual Returns and Max Drawdowns

S&P 500 & S&P/TSX 60, 1988-2017

2018 Stock Market Volatility
2017 was noteworthy for having a slow and steady gain throughout the year. At no time in the US or Canada did we see markets fall by more than 5% from their previous highs. In fact, as you can see on the chart, going back to 2011, most of the years have seen smaller intra year declines than the average over the entire period.

Losses in a portfolio are never going to feel good. However, we should put the current losses into context. The recent volatility we’ve seen, with drops between 5% and 10%, is not only completely normal, but still below average for intra year market movements. In fact, it’s this uncertainly, or risk, that is a real part of why we expect higher returns in stocks than safer investments like bonds, CDs or GICs.

Also, it’s important to keep in mind that these volatile movements in the stock market are only one part of a diversified portfolio. By combining stocks in the US, Canada and the rest of the world with less volatile bonds, your allocation can be tailored to meet your investing needs.

Persevering through the short-term ups and downs are part of the price investors must pay to capture those long-term higher rates of return. Ensuring that you have the right amount of those less volatile components in a portfolio can help you stick to the long term plan you’ve set in place.

Source: Morningstar Direct 2018. Indexes are unmanaged baskets of securities that are not available for direct investment by investors. Index performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. All investments involve risk, including the loss of principal and cannot be guaranteed against loss by a bank, custodian, or any other financial institution.

 

Terry Ritchie featured in The Insurance & Investment Journal article, Managing Cross-Border Clients

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From the Insurance & Investment Journal article:

Managing cross-border clients is a challenging area for advisors that requires thorough knowledge on how to handle life insurance, investments, taxes and pensions while respecting two countries’ rules and regulations.

The Insurance and Investment Journal spoke to U.S-Canada cross-border expert Terry Ritchie, a director at Cardinal Point Wealth Management, who’s specialized in the field for more than 25 years to find some answers. He says if you don’t have knowledge or experience it is very easy to mess things up for your client.

Read the article here