STRATEGY SHEET
March 1996
How to Increase Returns
While Lowering Risk
© Talbot Stevens
To minimize total risk, we need to match the type of investment with the length of the investment. To achieve long-term investment objectives, like saving for retirement, equity funds are the safest way to get the higher, historical, long-term returns of stock markets.
Let's look further at how proper diversification using mutual funds can not only reduce your real risk, but at the same time result in higher returns.
To diversify effectively, you need to not only have your money spread among the three basic classes of investments: equities, bonds and cash-like investments like GICs or treasury bills, you need to have that money invested in different areas of the world.
For economic and political reasons, it doesn't make sense to put all of your eggs in one basket — or country, no matter what country you live in.
To illustrate the importance of getting your money outside of Canada, which represents less than 3% of the equity opportunities around the world, let's look at the long-term average returns of various categories of equity funds.
Over a period of at least 10 years, Canadian equity funds have averaged about 10% a year. Long-term returns for American equity funds have averaged about 12% per year.
But if you didn't restrict your mutual fund manager to North America, and allowed him or her to take advantage of opportunities anywhere in the world, you can expect higher returns, and international equity funds reflect this with long-term returns of about 13%.
When you consider the annual returns, some people look at the small 2% or 3% improvement and say, big deal, why bother? But anyone understanding the magic of compounding knows it is a big deal.
If you had invested $10,000 over a 30-year period and averaged 10% returns, you would have $175,000. Averaging 13% returns, an improvement of only 3% a year, grows to $390,000 — more than twice as much.
By diversifying outside of Canada, you naturally reduce economic, political, and currency risk, while at the same time increasing returns.
Note that we are unique in getting this double benefit of higher returns and lower risk by getting our money out of Canada. Americans don't get a 3% annual improve-ment. Isn't it great to live in Canada!
This also illustrates the cost of patriotism. By keeping your money in Canada, you have less diversification and hence higher risk, while accepting 3% lower annual returns.
Now you know why global investing is one of the hottest areas in mutual funds, and why it's important to take advantage of the 20% foreign content limit in your RRSP.