30 January, 2007
What a wild and wonderful year 2006 was: oil jumped 30% to trade above $79 US and then fell back to virtually the same price that it had started the year at; Canada’s stock market experienced its fourth consecutive year of double-digit growth; the US experienced its first year of double-digit growth in 7 years and has now finally broken-even with December, 1998; interest rates were up marginally in Canada and slightly over a quarter-point in the US; and Europe and Asia continue to grow strongly although unevenly.
What more could an investor want ? Let me rephrase that: what more could a well-diversified investor want ? The investors who bet everything on oil and Gas at the high are not feeling too happy right now; they have lost 30%. The people who put everything into Japan after its 40% gain in 2005 only made about 7% this year, while people who got out of China after a weak 2005 missed a 34% gain in 2006. The US finally produced some growth, but was still extremely weak in many sectors.
How can investors expect their portfolios to perform in relation to the markets ? Well, no diversified portfolio will ever hit the highs of the markets, however, it should avoid the lows as well. If an investor had invested $100 in China (HANG SENG) and a $100 in Japan (NIKKEI) at the beginning of 2005, that portfolio would have earned 22%, well below Japan’s high of 40% but well above China’s low of 4.5%. In 2006, the same 50-50 portfolio would have earned not quite 21%, well below China’s 34% but well above Japan’s not quite 7%. Let’s see, 22% in 2005 and 21% in 2006. Surprisingly stable given the huge year to year differences for each individual country.
Consider also that oil fell 30% from its high and ended the year flat. Compare that to an almost 9% average growth for resource-based mutual funds. Many of the mutual funds benefited from the fact that oil’s fall was partially offset by price growth in other resources. It is almost impossible to accurately predict the price movements of individual stocks, bonds, commodities, economic sectors or individual countries.
It is not at all impossible, however, to reduce a portfolio’s risk by including investments that move in different directions at least some of the time. In fact, that is the art of investing, and it is known as diversification.
Some of your investments will have risen much faster in the past year than others. It would be a mistake, however, to automatically sell the underdogs and buy the overachievers. If we had done that at the end of 2005, we would have sold China after a weak year to have bought Japan after a strong year. Our 2006 growth would then have been the 7% that Japan grew and not the 34% that China grew, or the 21% growth of a balanced portfolio.
Please see the attached Appendix A for the figures I have used above, among others.
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