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Rule of thumb: How much of my portfolio should be globally diversified?

September 2, 2011 - 2 comments

Chris Philips, CFA, a senior analyst in Vanguard's Investment Strategy Group, gave his opinion on Fitting International Stocks in a Portfolio from a U.S. investor’s viewpoint:

“We think that for most investors, a great starting point is 20%. You get a significant amount of historical diversification benefit. You get some exposure to non-U.S. stocks and the fluctuations of currency, of markets, of economies globally. We do believe that if you are so interested, you can extend that to maybe 30% or 40%, and we'd actually be comfortable going all the way up to maybe market-cap-proportional, which would currently be around 55%. But that 20% range is probably a great starting point for somebody to look at.”

From a historical Canadian viewpoint, diversifying up to 50% of your equity holdings to non-Canadian stocks has resulted in a significant reduction in volatility.  Incremental reductions in volatility have been obtained by diversifying even further than 50% away from Canadian stocks (although some investors may be uncomfortable with the additional currency risk inherent with this strategy).  In the graph below, historical 3-year rolling standard deviations are shown (vertical axis) for four hypothetical balanced index portfolios (rebalanced annually) with various allocations to Canadian, U.S. and International equities:



As can be seen in the graph above, in almost all periods studied, balanced index portfolios with higher allocations to U.S. and International stocks (Portfolios 2, 3 and 4) have exhibited lower volatility, relative to a balanced index portfolio comprised entirely of Canadian stocks (Portfolio 1). 

There are a number of reasons for this large reduction in volatility, mainly:

  • The S&P/TSX Capped Composite Index has only a small allocation to defensive stocks, such as consumer staples and utilities (approximately 4.4%), which are less volatile than cyclical stocks.  In comparison, approximately 13.9% of the MSCI World Index is comprised of defensive stocks.
  • The U.S. dollar (a “reserve” currency) has historically been negatively correlated with world equity returns.  When world equity markets tank, there is a “flight to safety” by investors from equities to U.S. treasuries, increasing demand for the U.S. dollar.  For the Canadian investor with a portion of their portfolio invested in U.S. stocks, their long position in the appreciating U.S. currency can act to offset some of their losses on the U.S. stock position.

Interestingly enough, the historical annualized returns (from December 1979 to June 2011) are almost identical for all four hypothetical balanced index portfolios, showing that a globally diversified portfolio has historically resulted in similar returns with reduced volatility (something all nervous investors would have been delighted with):


By: Justin Bender with 2 comments.
Filed under: Diversification
  07/09/2011 2:24:52 PM
Hi Moira – did you mean that from a behavioural point of view, it is difficult for an investor in reality to move funds from Canadian equities into international equities? I would certainly agree with you on that argument. As for correlations between major equity markets, in times of crisis they tend to rise close to 1 in the short term; however, as Larry Swedroe pointed out in his recent blog, "International Diversification Still Works, if You’re Patient," the benefits can still be seen over the long term.
  07/09/2011 11:26:05 AM
Moira Hudgin
A useful analysis, but it is difficult given the current volatility of international markets to incorporate this into one's portfolio. The devil is in the details. Further, given the global nature of the large corporations in the US and other major markets, there is probably some cross correlation between the different indexes.

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