Christian Charest: For Morningstar, I'm Christian Charest. All this week, we're talking about global diversification. There is one common misconception among retail investors when it comes to determining the riskiness of various asset classes, namely, we tend to think of Canadian equities as somehow safer than foreign equities.
This is very clear in one area, in particular, and that's funds of funds. Those programs usually have different options that go from safer to more aggressive. The safer options tend to have more domestic equity allocation, whereas the more aggressive options tend to have more foreign equity exposure.
But is it really riskier to invest outside the country? I'm here with Dr. Paul Kaplan, Morningstar Canada's director of research to set the record straight on this topic. Now Paul, let's start with talking about this: why do you think there is this bias among investors?
Paul Kaplan: Well, I think it's a behavioural type of bias. We tend to think of the things we're most familiar with as being less risky. So, we're more familiar in Canada with various Canadian companies. So, we might think of those companies as being less risky than companies in other parts of the world, or we might even think of the whole Canadian market as less risky because we are more familiar with it compared to other markets.
Charest: But it doesn't necessarily mean that these companies are better managed. For example, I like my Tim Horton’s coffee and I always see a big lineup at my local TD branch, but that doesn't necessarily mean that those are good potential investments.
Kaplan: That's right. Just because something is more familiar to you does not mean it's less risky.
Charest: This could also be a spillover from what we hear in the U.S. media, where non-U.S. companies tend to be presented as riskier than domestic ones, but the situation over there is very different.
Kaplan: Yes, it's quite different. The U.S. is a large economy with a very large well-developed equity market, and very well diversified across various industries. It's just a different market than Canada, which tends to be more concentrated in just a few industries.
Charest: From a U.S. point of view, the non-U.S. markets by default are going to be less diversified, since the U.S. is the most diversified market in the world. Now, there is also the issue of currencies.
Kaplan: Yes.
Charest: Currency tends to be perceived as a risk when investing, but is it really a risk?
Kaplan: Over the short run it can certainly be a risk because currencies can and do fluctuate, there is certainly fluctuation between the value of the Canadian dollar versus the U.S. dollar. Or for example, the Canadian dollar versus the euro or the Japanese yen, and certainly these things can be a factor over the short run.
From a longer-term perspective, however, it may not be the case because over the long run the fluctuation of going up and down might cancel each other out, and really over the long run it should be a less of a consideration. But over the short run yes, one has to take currencies into consideration.
Charest: Another thing to consider is the fact that a lot of large-cap companies tend to be more global in nature. So where their head office is located isn't as important as it used to be.
Kaplan: That's right. And there are even some very large Canadian companies, that do business globally, and therefore have exposure to global markets.
Charest: Now, what about emerging markets? Certainly there are risks that are specific to emerging markets, but does that mean that risk-averse investors should avoid them altogether?
Kaplan: Not avoid them altogether. I think emerging markets should play a role in a well-diversified equity portfolio; there should at least be a small allocation to emerging markets, as part of global diversification.
However, there are some risks that are particular to emerging markets versus developed markets, they do tend to be more volatile, they do have less-developed economies, they have less-developed legal structures and their institutions can be can quite different and risky. In some markets for example, there's the risk of government expropriation of your investment. So, definitely emerging markets would be more risky, but that doesn't mean they should be excluded.
Charest: But overall there is a positive effect to including them in a well-diversified portfolio?
Kaplan: Yes, because over the long run they – yes they are risky, but they also can produce some very good returns.
Charest: So, the main take away is that it's more about the risk factors that affect your investments because those factors are more meaningful toward determining risk as opposed to where those investments are located.
Kaplan: Yeah, that's right. A well-diversified portfolio is one that has exposures to various risk factors around the world and the important thing is not the location of a particular company, but rather what risk it is exposed to and what returns it might produce.
Charest: Okay, thank you very much Paul. For more on Morningstar's Global Diversification Week, you can click on the links right below the video player, and check back with us regularly for more news and updates.
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