Tuesday, 10 November 2009

Foreign Diversification Cognitive Dissonance

Take a look at this chart and tell me what the heck is going on?

Isn't diversification into foreign equities supposed to reduce portfolio volatility and increase returns through non-correlation and rebalancing? Yet the simple all-Canadian portfolio with 5% T-Bills, 30% All Canadian Bonds and 65% TSX Composite Equities would seem to have done about the same as an international portfolio with the same fixed income but with equity holdings of 25% TSX, 15% S&P 500, 15% MSCI EAFE developed country and 10% Emerging Markets. The cumulative compound return of the two portfolios after 22 years ended up almost identical - the Canadian portfolio at 250% and the International at 256%.

Twenty two years is starting to be a long time waiting for international diversification to help a Canadian investor. Is the data somehow wrong? I used financial advisor and frequent Financial Webring contributor Norbert Schlenker's downloadable time series spreadsheet from his Libra Investment Management website. The data (unique and no doubt compiled with considerable effort) has been adjusted for inflation and converted back into Canadian dollars from unhedged foreign holdings.

This graph goes against the conclusions in such classic books as Roger Gibson's Asset Allocation (my review) to the effect that international diversification helps considerably. Gibson figured things in US dollars instead of the Canadian dollars in this data. Is Canada somehow special and its equity market a mirror of an international portfolio?

1 comment:

Matt said...

This is an interesting analysis, but I think limited. Investing isn't just about maximizing return, it's about limiting risk. I don't invest abroad to make more money. I invest abroad to deal with the specific risk that Canada will underperform or face a significant financial crisis.

Something bad could happen to Canada. If something bad happens to Canada that doesn't happen to other countries, or doesn't effect them as badly, then having some of your portfolio in foreign investments will be a very good thing. As an investor, I don't much care what the correlation between the TSX and the AEFE indexes has been over the past 20 years, I care what it will be over the next 20 years. And the answer is that I don't know, and no one else does either.

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