With three trading days left in 2011, it looks like the Canadian Edge Portfolio Conservative Holdings are headed for a total return of around 13 percent. That includes a 54 percent year-to-date loss booked on now-sold Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF).

Meanwhile, the Aggressive Holdings are off about 8 percent. That includes year-to-date losses of roughly 54 and 83 percent on closed-out Perpetual Energy Inc (TSX: PMT, OTC: PMGYF) and Yellow Media Inc (TSX: YLO, OTC: YLWPF), respectively. And our three closed-end mutual funds are registering an average loss of about 7 percent.

Both halves of the Portfolio and the funds look set to beat the broad-based Standard & Poor’s/Toronto Stock Exchange Composite Index, which is off about 11 percent. That includes a 2 percent retreat in the Canadian dollar since Jan. 1.

Clearly, keeping conservative paid off 2011, while taking on risk in pursuit of greater reward did not.

Interestingly, that’s not the way things looked early in the year, as investors seemed to chase high yields almost without regard to risk or to the underlying business paying the dividend. But by summer that mood was shifted 180 degrees by fallout from the Japanese earthquake/tsunami, the threat to global oil supplies caused by the Arab spring, food and energy inflation in the developing world, the US budget impasse and, finally, a worsening European sovereign debt crisis.

As a result, investors bought stocks they considered safe and sold everything they perceived carried risk. The performance gap has narrowed a bit since its peak in early October. But the top eight performing CE Portfolio recommendations are up 40 percent on average this year, versus a loss of 36 percent for the bottom eight performers. That’s the widest performance gap in the history of Canadian Edge, including 2008.

Rebalance Now

In the December issue I urged investors to rebalance their portfolios by the end of the year with partial sales of huge winners to offset sales of losers like Capstone, Perpetual and Yellow. That definitively doesn’t mean selling all of positions in stocks like AltaGas Ltd (TSX: ALA, OTC: ATGFF). But selling a little brings a sharply appreciating stock back into balance with the rest of the portfolio, while keeping you in the game for further gains in great companies.

The second part of the advice is to redeploy funds from partial sales of winners and total sales of losers to buy stocks you don’t already own. These would preferably be stocks in the Portfolio, though other How They Rate companies trading below buy target are also acceptable.

This remains my primary advice now, whether you hold Canadian Edge stocks inside or outside of an IRA or other tax-deferred retirement account. If you hold them outside, you’ll need to take care to balance gains and losses to avoid taxes. Holding them inside, there are no tax consequences of rebalancing. But as we move into the New Year, holding roughly equal amounts of a range of high quality stocks is the best way to protect you from the greatest risk of 2012.

In this uncertain environment of jagged economic growth, even the strongest looking companies can suffer a setback. And the more of your overall portfolio committed to a single stock or group of stocks, the greater the potential for wealth destruction.

Over-weighting was definitely the greatest risk of 2011 for owners of dividend-paying stocks. Despite the much-heralded “Black Swan” events noted above–and almost unprecedented volatility–the number of companies that truly imploded was relatively small. In fact, most stocks that crashed during 2011 wound up rallying sharply by the end of the year, either pushing into the black or narrowing losses sharply.

As I pointed out in the December Portfolio Update, Parkland Fuel Corp (TSX: PKI, OTC: PKIUF) at one point in 2011 had lost nearly half its value. But with a few days left in the year, it’s now up nearly 20 percent. Similarly, once-large losses at Bird Construction Inc (TSX: BDT, OTC: BIRDF), Colabor Group Inc (TSX: GCL, OTC: COLFF), Davis + Henderson Income Corp (TSX: DH, OTC: DHIFF) and Student Transportation Inc (TSX: STB, NSDQ: STB) have either turned to yearly gains, or nearly have.

These companies were battered at times in 2011’s up-and-down market. But they stayed strong as businesses, investors noticed and their stocks recovered–and all the while they kept paying generous dividends.

That was the only real difference between the Parklands and the Capstones of 2011. But failure to stay strong as businesses proved a critical flaw for the latter, turning small losses into huge ones. And, unfortunately, at least some investors were over-weighted in them, either because they really loaded up when the stocks were flying high or by buying more as prices fell.

As we enter another year, I can’t emphasize enough that no one should ever average down in a falling dividend-paying stock. Doubling down is the only way a single company’s stumble can metastasize into a disaster for your entire portfolio. And avoiding the practice is one way to ensure that you’ll never be taken down by a single stock.

To be sure, I took some big hits this year with now-sold Capstone, Perpetual and Yellow. And several stocks I’m still holding also took on water this year, namely Ag Growth International Inc (TSX: AFN, OTC: AGGZF), Just Energy Group Inc (TSX: JE, OTC: JSTEF) and PHX Energy Services Corp (TSX: PHX, OTC: PHXHF).

Were these six stocks over-weighted in the CE Portfolio, it would have been a very bad year indeed. And judging from some of the feedback I’ve received, at least some readers did fall into this trap, with very severe consequences.

As it was, held in balance with the rest of the CE Portfolio, they hurt our returns, but not enough to keep us from being well in the black overall. And that’s in a year when both the Canadian market and Canadian dollar lost ground. That’s the best testament to diversification and balance I can think of.

Improved Returns, Same Risks

I’ve taken some steps the past several months to better avoid the next Yellow or Capstone. One of these was to toughen up the CE Safety Rating System to give more weight to credit market exposure. Another is simply to have no tolerance for any company that suddenly retracts guidance, as we did selling Capstone earlier this month, though the company has yet to officially cut its dividend.

These strategies aren’t foolproof, any more than what I was doing before. It’s nearly certain that one of the 20 Conservative Holdings or 14 Aggressive Holdings is going to get some bad news in the next 12 months. And when it does we’ll dump it and replace it with another stock.

At this point I’m particularly concerned about the potential impact of the drop in natural gas prices to barely USD3 per million British thermal units on gas producers. Although I’ve limited direct Portfolio exposure to companies aggressively focused on gas, there’s still some risk in Enerplus Corp (TSX: ERF, NYSE: ERF), for example.

There’s a huge difference, however, between possible risks and what proves to be reality. Enerplus is still a strong company with good dividend coverage and healthy production growth. I don’t expect its numbers to weaken in coming quarters. And I’m comfortable sticking with it as long as they don’t, as it is just one stock in a broadly diversified Portfolio. Even if it does weaken, it won’t flatten the Portfolio. And if the company performs as I anticipate, we can look forward to big returns in 2012.

Moreover, if one thing is certain heading into 2012 it’s that investor pessimism is as bad as it’s ever been. In fact, based on feedback I’ve received from many readers, it may be even worse than it was in early 2009.

That’s truly remarkable, considering the North American economy actually grew in 2011 and that much of the stock market posted strong returns. Extreme pessimism is a major reason why I think 2012 will be good to investors in dividend-paying Canadian stocks who diversify, balance and focus on the health of companies’ underlying businesses.

Another reason to be bullish–and also a huge contrast with 2008-09–is that corporate borrowing rates remain the lowest in decades. CE Portfolio companies have eliminated near-term refinancing risk, slashing interest costs in the process. Now they’re using the cheapest capital ever to finance low risk growth. And, above all, they’re making sure everything they do is sustainable based on conservative assumptions for their businesses.

Yes, there are some dark clouds out there. The eurozone faces a decision point on economic integration. The US government is up for grabs in the pending November election, and any decisions between now and then are likely to be extremely measured, at best. Meanwhile, China has declared its era of breakneck economic growth over, yielding to a “modest” pace of 7 to 8 percent a year.

Any and all of those factors could have an impact on global growth in 2012, and therefore stock market performance. Canada’s natural resource ties means the Canadian dollar would likely suffer from any future rush to safety–i.e. US Treasury bonds–as it did in 2011.

Those are all unknowns, however. What we do know is the tight credit that spawned the historic 2008 crash is nowhere in sight. Neither is the North American economy in recession, as it was before the crash. And, in stark contrast to summer 2008, businesses, investors and governments are definitely not betting on robust global growth for the coming year.

With everyone already hunkered down, it’s going to take a lot more than we’ve seen so far–or even than we saw in 2008–to set off a 2008-style market panic. And since that’s what so many seem to be expecting, it stands to reason that it won’t take much if any really good news to beat expectations, triggering sizeable stock market gains.

A quick glance at the Canadian Edge Portfolio reveals that we’re focused on conservatively run companies with good balance sheets. These companies either operate in business niches that are highly recession-resistant or else are protected operationally by relying on long-term contracts with creditworthy partners.

Sometimes even these companies fall apart before we can get rid of them, and we suffer losses as a result. But with very few exceptions they’ve weathered 2011, and nearly two-thirds of them are in the black for the year.

That’s a pretty good track they won’t have trouble building on if macro conditions turn out to be only slightly better than the calamity the nearly unanimously bearish consensus is pricing in. And that’s the best possible reason to stick with our CE stocks and collect their generous dividends–a growing number of which are set for increases in 2012 and beyond.

We’ll have more on our forecasts and strategies for 2012, including tax issues, in the January issue of Canadian Edge. It will be e-mailed to you and published at www.CanadianEdge.com on Friday, Jan. 6.

Until then, whereever you are, Happy New Year.