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4 reasons to diversify
- Not all types of investments perform well at the same time.
- Different types of investments are affected differently by world events and changes in economic factors such as interest rates, exchange rates and inflation rates.
- Diversification enables you to build a portfolio with generally less risk than the combined risks of the individual securities.
- If your portfolio is not diversified, it may carry unnecessary risk.
There are many different ways to diversify your portfolio, including by asset class, industry or country.
There are generally three types of markets to choose from when thinking about international diversification:
- Developed market – generally defined as a country with well-developed capital markets and economy. Developed market countries may be less risky than countries in emerging or frontier markets.
- Emerging market – generally defined as a country that does not have as well-developed an economy or capital markets when compared to a country in the developed market. Emerging market countries may be riskier than developed market countries.
- Frontier market – generally defined as a country that has signs of development, but cannot be considered an emerging market. Frontier markets generally carry the highest investment risk.
For examples of the countries in each category, see the Annual Country Classification Review available from S&P Dow Jones Indices.
Because risk and return are related, investing in emerging and frontier markets may expose investors to a higher potential rate of return – but also bigger potential losses – compared to investing in the developed market.
Why invest in various countries?
Because Canada is over-weighted in resource and financial sectors, achieving broad diversification in Canada alone can be challenging. Investing in different international markets can provide exposure to additional market sectors that may be unavailable in Canada. Large markets, like the U.S. can also provide global exposure due to the higher number of large multi-national companies headquartered there.
Risks of diversifying by country
All investing comes with certain amounts of investment risk. Here are a few to keep in mind if you are investing outside of Canada:
- Foreign investment risk – The risk of loss when investing in foreign countries. When you buy foreign investments (for example, the shares of companies in emerging markets) you face risks that do not exist in Canada. For example, the risk of nationalization.
- Political risk – The risk of loss when there are changes to the political leaders or policies in a country. For example, if a new government comes into power, it may decide to make new policies. Sometimes these changes can be seen as good for business, and sometimes not. They may lead to changes in inflation and interest rates, which in turn may affect stock prices. An act of terrorism can also lead to a downturn in economic activity and a fall in stock prices.
- Currency risk – The risk of losing money because of a movement in the exchange rate. For example, if the U.S. dollar becomes less valuable relative to the Canadian dollar, your U.S. stocks will be worth less in Canadian dollars.
- Credit risk – The risk that the government entity or company that issued the bond will run into financial difficulties and won’t be able to pay the interest or repay the principal at maturity.
How foreign investments are taxed
If you receive interest, dividends or capital gains from investments outside Canada, the equivalent Canadian dollar value must be reported on your Canadian tax return and will be taxed accordingly. Foreign dividends do not qualify for the dividend tax credit. Interest-bearing investments like Certificates of Deposit (CDs) from the United States are taxed as income.
A withholding tax may be deducted from your foreign investment income. However, you may be able to claim a foreign tax credit to prevent double taxation.
If you own specified foreign property costing more than $100,000, you must complete form T1135, Foreign Income Verification Statement, which can be filed electronically. For taxpayers with less than $250,000 of specified foreign property, the reporting method has been simplified for 2015 and future tax years. However, detailed reporting is still required for those with foreign property costing more than $250,000.
Learn more about how investments are taxed.
A financial advisor can help you decide whether international investing is right for your portfolio and financial goals. Learn more about choosing an advisor.
You can’t completely eliminate investment risk from your portfolio, but diversification can help reduce it.