Investors have always been told that diversification is one of the best ways to reduce the risk associated with a portfolio. But they often aren't told the whole story, and could be missing out on lucrative opportunities as a result.

Diversifiying your investments can mean a number of things. There's diversifying by asset class — stocks, bonds, commodities and cash. By sector — technology, health care, financials or energy. Diversifying by style — value, growth. And by size — small cap, large cap.

But what about diversifying by geography?

It's something many advisers and investment gurus don't cover in great depth. And in the face of the world's fragile economy these days, it's not surprising that some Canadian investors are wondering if it would be better to just play in their own yard.

After all, global equity markets have seemed to rise and fall in unison lately. And when the correlation isn't as strong, it seems to be because the markets overseas have been performing worse than Canada's.

Investors look at the growing list of European countries, ranging from Ireland to Italy, lurching from debt crisis to debt crisis. They see worries of a debt-default and economic collapse in Greece. They see a Japanese market that has been stagnating for the better part of two decades and which is still reeling from the 2011 tsunami. They see inflation ratcheting up in several emerging economies. They see a U.S. economy with a poisonous political atmosphere and a huge fiscal imbalance. They see a Canadian dollar that has rallied against many currencies – including the U.S. greenback – which reduces returns once they are converted back into loonies.

"There is no economy in the world, whether low-income countries, emerging markets, middle-income countries or super advanced economies, that will be immune to the crisis that we see not only unfolding but escalating," declared IMF head Christine Lagarde in mid-December.

So the question must be put: Why not invest in Canada and avoid all the turmoil?

Beyond our borders

As it turns out, when pressed the experts say international diversification still makes sense, despite the economic gloom hanging over many foreign nations.

When pressed, some investing experts say international diversification makes more sense now than it has in many years.

In fact, some even say it makes more sense than it has in many years.

That's the thesis of a couple of economists at BMO Nesbitt Burns. Doug Porter and Robert Kavcic noted in a late November analysis that the total return for the Toronto market and the S&P 500 index in the U.S. has been almost identical over the past 40 years.

"However … there have been enormous and sustained difference between the markets within that period, of which most investors could not afford to be on the wrong side," they write.

They argue that because Canada's stock market has outperformed and the loonie is still close to par with the U.S. dollar, "the case for international diversification for a Canadian investor is certainly more compelling now … than it has been for much of the past 15 years."

The big institutional money managers in Canada are certainly not abandoning the rest of the world. Of the $50.3 billion the Canada Pension Plan (CPP) investment fund had in publicly-traded equities as of Sept. 30, 2011, more than $31 billion – or 62 per cent – was invested outside the country in 2,600 international corporations.

In its most recent statement, the CPP Investment Board said it was "continuing to diversify the portfolio by asset class, risk/return characteristics and geography, with a particular focus on increasing international investments."  

And it's not just the CPP. OECD figures show that Canadian pension funds as a group hold the majority of their equity investments outside the country.

Canada is a narrow bet

Many analysts say the concentrated state of Canada's stock market is the biggest reason why foreign diversification makes sense despite the economic turmoil around the globe. In the benchmark index of the TSX, just three sectors – financials, energy, and materials – account for more than 70 per cent of the value of the index.

"The resource sector plays such a big part [in Canada]," says Ian Nakamoto, director of research at MacDougall, MacDougall & MacTier. "If you want to diversify into health care or technology, you pretty much have to tap into the U.S. market."

Foreign exposure can also provide access to faster growing economies. But "it's not without its risks," Nakamoto acknowledges. Those risks can include changing laws and tax rates, not to mention government instability. 

There's also the fact that the Canadian stock market accounts for just three to five per cent of the global market. People who only hold domestic investments are potentially missing out on a wide range of lucrative investing opportunities.

"The sheer size of the opportunity set presented by foreign markets justifies international investing," says Shawn Levine, an analyst at TD Waterhouse.

Levine also points out that a strong Canadian dollar can make foreign investing less expensive and will boost returns if the loonie slides back.

Of course, that depends on the relative change and direction of the particular exchange rate. If an investor wants international diversification without the currency risk, there are a number of currency-hedged mutual funds and exchange-traded funds (ETFs) that can accomplish this.

The bottom line? The experts agree that, yes, parts of Europe may look like scary places to invest right now. But they say your portfolio will likely thank you in the long run if it gets to go on a few carefully planned and researched trips beyond our borders.

Stock market returns in 2011 (excluding dividends)

Country Index Return (%)
Canada S&P/TSX Composite - 11.1%
United States Dow Jones Industrial Average + 5.5%
United States S&P 500 - 0.04%
Britain FTSE 100 - 5.6%
Germany DAX - 14.7%
Australia S&P/ASX 200 - 14.5%
Japan Nikkei 225 - 17.3%
France CAC 40 -17.0%
Hong Kong Hang Seng - 20.0%
India Sensex 30 - 24.6%