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Diversification and 2012: The Year in Review

Global economic and political uncertainty suggested to many people that
2012 would end on a negative note, but many investors benefited from
pleasant surprises that greeted them as a volatile year wound down.

Global economic and political uncertainty suggested to many people that 2012 would end on a negative note, but many investors benefited from pleasant surprises that greeted them as a volatile year wound down.

Highlights and lowlights of stock market activity in the U.S. in 2012.

Perhaps the biggest surprise of 2012 was the strength in stock and bond prices around the world despite a steady stream of discouraging news events. Markets that failed to reflect their pessimistic assessment of the future often flummoxed individual investors and professionals alike. The fiscal cliff showdown loomed large in the media and then basically disappeared. President Obama’s re-election did not roil U.S. markets and the much-anticipated disaster in the euro zone was averted. The bond market remained unexpectedly robust and China’s economy and stock market did not crash, in defiance of many observers who said it would.

U.S. remains an economic powerhouse
Despite the justifiable concerns wrought by the U.S. fiscal cliff, I include investing in the U.S. as a valuable component of our client’s international diversification strategy. (This diversification strategy is based on our equity allocations of one-third each among Canada, the U.S. and international countries regardless of the percentage of equities held). As an economic power-house with its vast internal market, highly educated workers and stable business infrastructure, more foreign investors are flocking to U.S. shores. (Source: The United States: Revival of an Economic Powerhouse by Douglas van den Berghe, Managing Director, Investment Consulting Associates (ICA) 2012)
And, most of the U.S. economic indicators continued to improve in 2012. For example, the labour market added new jobs in December, many of which were full-time and of good quality, the average workweek edged higher and the gain in average hourly earnings was the best since 2011. The growing strength of the housing sector helped buoy consumer balance sheets and drove higher consumer spending. While the giant south of our borders still has work to do, conditions improved during 2012.

Another surprise was that Canada lagged badly and global diversification turned out to be the right choice – despite global economic uncertainty amplified by negative media reports. Two examples that struck fear into the hearts of many investors and kept them focused on Canada are listed below.

From the first quarter: “Unemployment in the euro zone jumped to a 15-year high Thursday, while inflation unexpectedly accelerated.” (Brian Blackstone, “Poor Economic Data Slam Europe,” Wall Street Journal, March 2, 2012)

From the third quarter: “The US economy slowed sharply in the second quarter, growing just 1.5% as consumers slashed spending and businesses grew more cautious about hiring and investing, underscoring that an already wobbly recovery is losing even more steam.” (Neil Shah, “Weak Economy Heads Lower,” Wall Street Journal, July 28, 2012, referring to the U.S. Stock Market Performance)

Last year was a surprisingly good year to invest in U.S markets. Here are some key numbers that confirm the extent of U.S. stock market performance:

• The S&P 500 gained 13.4%, marking the benchmark U.S. index's largest annual return since 2009 and fourth-largest return in the last decade.
• The NASDAQ Composite Index was up nearly 16%. That's a vast improvement from a year ago, when the tech-heavy index fell 1.8%.
• 128 companies went public – the second-highest IPO total in the last five years.
• It was also a good year for small cap stocks as The Russell 2000 Index, which gauges U.S. small caps, returned 14.7% in 2012. (Source: Wyatt Investment Research, January 2, 2013)

I have written here before about the dangers of reacting to media “noise” (as illustrated in the above examples). “Noise” can scare investors into making wrong investment decisions as they stumble deeper into the trees, unable to see the forest and without a plan to get to the other side.

They are so conditioned to believe all they hear from media personalities, friends and colleagues that they forget the key to securing a strong financial future: Have a carefully considered investment plan, diversify your investment portfolio to include assets beyond Canada and rebalance those assets back to your optimum mix – at least annually.

What’s with Canada?
Canada was not the investment destination it once was in 2012 for a number of reasons. Analysts attributed Canada’s fall from grace to a range of factors, including the soft worldwide demand for energy and other resources, a drop in manufacturing, lower consumer spending, a cooling housing market, the sluggish U.S. recovery, and concerns over the U.S. fiscal cliff. Despite the economic headwinds, Canadian stocks delivered positive performance. For the calendar year, the S&P/TSX Composite Index delivered a 7.2% total return and the S&P/TSX 60 Index had an 8.1% return.

Time to leave home.: international diversification can bring relative safety and strong returns
Diversification is a long-accepted risk management technique that mixes a wide variety of investments within a portfolio. A portfolio containing different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. It’s a case of safety in numbers – well considered numbers, that is.

Global investing is a large part of portfolio diversification. By investing overseas, you have the opportunity to invest in dynamic international companies that may be growing faster than their Canadian or U.S. counterparts.

While foreign stocks and bonds are typically more volatile than, say, U.S. stocks, adding international exposure to a portfolio will normally reduce volatility and risk within the portfolio without lowering returns. A portfolio of 80% U.S. stocks and 20% international stocks will likely have similar yields with less risk than a portfolio of 100% U.S. stocks. (Source: http://www.investorhome.com/intl.htm )

Why global diversification won out in 2012
Global diversification was indeed a huge benefit to investors in 2012, as the once attractive Canadian equities sector lagged behind the rest of the world.

All major U.S. market indices were up substantially for 2012. The S&P 500 gained 13.4%, and with dividends included, logged a total return of 16%.

The NASDAQ Composite Index gained 15.9% for the year, and the Russell 2000, a popular benchmark for small company U.S. stocks, returned 16.3%. The Dow Jones Industrial Average gained 7.3%. The market’s strong performance came with lower volatility, as gauged by the CBOE Volatility Index, which had its largest annual decrease since 2009.

Non-U.S. developed markets performed even better. The MSCI World ex USA Index, a benchmark for large cap stocks in developed markets outside the U.S., returned 16.4%. The MSCI Emerging Markets Index returned 18.2%. Among 45 global stock markets, only three posted negative returns in local currency. And 12 markets posted total returns in excess of 25%. That surprised many analysts and investors. They were also surprised when The U.S. Central Bank and the European Central Bank came to the rescue and lifted threatened markets.

Rock bottom interest rates fuelled equity investing
Spooked investors who neglected diversification, and basically took U.S. and international equities off the table and bet on short-term fixed income because they assumed interest rates had to rise, were disappointed.

The fixedincome category was relatively soft as interest rates stayed low and the much – anticipated rate increase never materialized. Federal Reserve chairman Ben Bernanke said over the summer that he would keep interest rates open-ended, which means that no one (not even he) knows when he will increase them. Current interest rates set below the level of inflation are forcing conservative investors such as insurance companies and pension funds to move up the risk spectrum into new territory in search of yield. This is another excellent reason for some investors to consider increasing international diversification among stocks and bonds. The central banks are buying equity. For example, The Swiss National Bank invested in $6 billion worth of equity each month over the summer of 2012 in order to avoid negative- or low-yielding investments.

International diversification as a logical extension of a domestic portfolio
I think of an investment portfolio as a combination of Canadian, U.S. and international equities with domestic and global fixed-income investments.

While international diversification may help to reduce overall portfolio risk over time, there are important differences between domestic and U.S. and foreign investing that can affect the day-to-day volatility of international holdings:

• Political or economic instability in foreign countries could negatively affect foreign investments, especially in emerging markets.
• Fluctuating foreign exchange rates can increase or decrease the dollar value of an investment even if the security’s price remains unchanged.
• Financial information about specific companies in emerging markets can be difficult to obtain.

An aerial view of the forest
That’s a lot to digest, especially if you have been largely focused on Canadian investments and now accept the case for exploring new international horizons. I will go back to my earlier comments that as long as you have a solid, well-considered investment plan, rebalance your asset allocation annually, your investment portfolio may benefit from less volatility and potentially higher returns.

And, while keeping current with the world around you, turn down the media “noise” and avoid getting stuck in the trees by taking in an aerial view of the forest instead.

Jim Sanderson is a wealth advisor with more than 25 years in the investment services industry. The Jim Sanderson Group at Scotia McLeod specializes in creating and distributing wealth for successful individuals and corporations in the aggregate and roadbuilding industries across Canada. He helps his clients supported by a team of experts in insurance, merchant banking, trust and estates. Jim can be reached at jim.sanderson@scotiamcleod.com.
Visit his website at www.jimsandersongroup.com .