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In May, I travelled to New York to cross an item off my bucket list: seeing Billy Joel perform at Madison Square Garden. One of the highlights of the show came when a group of American servicemen and servicewomen joined Mr. Joel on stage during Goodnight, Saigon, his 1982 song about the Vietnam War. Arm in arm, they swayed back and forth as they sang the haunting chorus: "And we would all go down together."

Investors may be singing the same song as they open their portfolio statements these days. Since May 1, Canadian, U.S. and international equities have all declined in value. And those bonds that are supposed to be our safety net? They've been hit hard, too.

Most investors understand the trade-off that comes with diversification. They know, for example, that bonds are likely to deliver lower returns than stocks, but they expect those bonds will offer protection when equity markets go into a tailspin – and most of the time they're right. But as we've seen in recent months, it doesn't always work that way. Sometimes they all go down together.

Before you throw up your hands and declare that diversification is broken, however, let's try to figure out what's going on here. The culprit, it seems, is rising interest rates.

By most accounts, the Canadian economy is robust: GDP growth exceeded expectations in the first half of 2017. Central banks typically raise interest rates to slow economic growth and keep inflation in check, and as expected, the Bank of Canada increased its key lending rate to 0.75 per cent from 0.50 per cent in mid-July, the first rate hike in seven years. Many commentators are predicting another increase before the year is out.

The fixed income markets responded to the Bank of Canada's move by jacking up yields on all bonds: 10-year Government of Canada bonds topped 2 per cent in late July, for example, a lofty height we hadn't seen since 2014. That spike in yields caused the bond fund in your portfolio to fall hard. (See this article if you need a refresher on why bond prices fall when rates rise.) So that part is straightforward. But it doesn't explain why the equities in your portfolio are flagging, too. Or does it?

It turns out higher interest rates affect more than just bond prices. Whenever a country increases interest rates it tends to attract more foreign investors. That drives up demand for the currency: The loonie has seen a sharp rise from about 73 cents (U.S.) in early May to about 80 cents today. While a strengthening Canadian dollar is a boon for cross-border shoppers, it can have a negative impact on equity investors.

The strong loonie and higher interest rates have created tough times for Canada's oil producers, and the energy sector makes up about 20 per cent of the Canadian stock market. Since May 1, the S&P/TSX composite index has fallen only modestly, but almost all of that decline is thanks to energy stocks, which have experienced a double-digit plunge.

Of course, your diversified portfolio should also contain a healthy slice of foreign equities, which have shined during the past five years as Canadian stocks struggled by comparison. But here again the rising loonie has pummelled Canadians. Markets in both the United States and overseas generally delivered positive returns over the past four months in their native currencies, but the news hasn't been so good for anyone who measures their investment returns in Canadian dollars.

Consider the S&P 500 index of large U.S. stocks. It's up about 3 per cent since May 1 in U.S. dollars, but a Canadian holding an S&P 500 index fund didn't fare nearly so well. She would have seen her investment fall more than 5 per cent over the same period as the U.S. dollar tumbled in value against the loonie.

International stocks have also enjoyed a respectable run over the past four months, but the soaring loonie has dragged these returns into negative territory for Canadians, too.

So when all of the components in a globally diversified portfolio decline at the same time, what's an investor to do?

Nothing, really, except stay the course. Remember that we're talking about a few months of mildly disappointing returns, which is hardly reason to abandon a disciplined investment plan. Sure, there are strategies that might have helped reduce the losses, such as moving to short-term bonds (which are less sensitive to interest rate hikes) and using currency-hedged equity funds (which reduce the impact of a rising loonie on U.S. and international stocks). But for tactical moves such as this to be effective you need to get the timing right, and that is notoriously difficult to do.

Holding a mix of Canadian, U.S. and international stocks – as well as an allocation of bonds (or guaranteed investment certificates) to smooth out the ride – is not a recipe for consistent returns. Sometimes everything goes into the tank at the same time. But for those of us who can't forecast the future, broad diversification remains the best way to reduce risk and reap the rewards of long-term investing.

Dan Bortolotti, CFP, CIM, is an associate portfolio manager at PWL Capital in Toronto. He is the creator of Canadian Couch Potato, an award-winning blog about index investing.

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