The long-term case for emerging markets

I received this question recently: “Remind me again: why are emerging markets in my portfolio?” A good question. Emerging markets aren’t doing very well lately compared to the U.S. and many other developed markets; it makes sense to wonder why we would want to be invested in them.

I told him I didn’t know, that I must have accidentally hit the wrong button when I was putting the portfolio together … whoops.

Just kidding. There are actually many good reasons.

First of all, my house philosophy is to start with the idea that global diversification is valuable, and the long-term evidence supports that. So investing in emerging markets is a natural addition to this philosophy, even if it’s a small piece of the pie. 

Emerging markets make up about 20% of the world’s economies, but they also represent about 80% of the global population. Emerging markets are also relatively young, have little to no entitlement programs weighing on their growth, and are also economically growth-oriented when it comes to both technology and natural resources, among other sectors poised to impact the global economy in the future. These are rather significant observations. 

Furthermore, it’s important to reflect on the fact that only about 100 years ago, the United States was considered an emerging market but became the world’s leading developed market, so ignoring emerging markets could affect your long-term returns and cause you to miss out on the next big thing. Exposure to that potential value should be appealing.

And being exposed to emerging markets was certainly beneficial in the “lost decade” of 2000-10, during which they were among the best asset classes to own and carried globally diversified portfolios. In fact, in six of the past 12 decades, emerging markets outperformed developed countries; in other words, in 50% of the past 12 decades, emerging markets have outperformed developed countries, and in 50% they have underperformed.

Looking at it that way, we really should also ask ourselves, “Why do we invest in developed markets?” They encounter roughly the same decade-by-decade underperformance as emerging markets. We don’t ask this because we have short-term memories, and U.S. investors are usually U.S.-centric in their portfolios because “that’s what we know.” 

However, investing in emerging markets does come with a large number of risks (although at times, these risks apply to developed markets, too): political, volatility, liquidity, and currency, to name a few. Furthermore, many emerging markets struggle with the development of an overall economic and securities infrastructure. Meanwhile, some emerging markets do not align well with investor interests. This is why you often see such uneven performance among emerging economies, and it’s why emerging markets are scarcely represented in many traditional portfolios. Investing in them is simply not for the faint of heart. 

(Continued)

 

That said, there are risks involved in investing in any country in the world. Liquidity (or rather, the lack of liquidity) also plays a large part in volatility, particularly in emerging markets. If there aren’t enough participants in the market and liquidity dries up, that can dramatically intensify a market correction. All markets have faced corrections, though. We cannot predict when the next correction will occur in any particular market, and if you invest in stocks, whether you know it or not, you are accepting that market volatility is simply a fact of investing life. (Note: if you don’t accept this truth, you will likely fail miserably at investing.)

Emerging markets are certainly not a short-term investment. But neither are developed markets like the U.S. As the historical evidence suggests, emerging markets are worth considering even in small doses, even if it may take more than a decade to see the value. Some folks don’t like waiting that long. That’s okay, but remember: the historical evidence suggests that all stock investments face similar issues and cycles. Spreading the equity risks around the globe seems like a sensible strategy.

Michael Dubis is a fee-only certified financial planner and president of Michael A. Dubis Financial Planning, LLC. He is a former adjunct lecturer at the University of Wisconsin Business School James A. Graaskamp Center for Real Estate. Mike can be reached at financialperspectives@gmail.com.
This article contains the opinions of the author. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services described in this website or that of the author’s. Mike Dubis does not guarantee the relevancy, appropriateness, or accuracy of any outside information or links. Mike Dubis does not render or offer to render personalized investment advice or financial planning advice through this medium. All references that might be made to an investment or portfolio's performance are based on historical data and one should not assume that this performance will continue in the future.
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