Lower Risk and Increase Returns by Investing in Emerging Markets

The investment business is always looking for the next hot theme or style to lure investors in the water. Inevitably, some people get burned and decide to invest in something else rather than understand their mistakes.

In 1994, for example, emerging markets sizzled and investors snapped up stocks of almost any company operating in Latin America. When Mexico collapsed in December 1994, other markets got hit too and many Latin American funds will end 1995 in the red.

But rather than worry about short-term performance, investors should think about the long-term and make emerging market stocks or stock mutual funds a key element of their equity portfolio.

One of the most important reasons they should do so is because they can actually lower the risk of an equity portfolio. Sure, emerging markets are, in general more volatile than those in developed countries. But when stock markets in the U.S., Japan and Western Europe drop, emerging markets tend not to fall in sympathy, according to Campbell R. Harvey, a Duke University Professor. What's more, they massively outperform developed country stock markets.

"Inclusion of emerging market assets in a…v will significantly reduce portfolio volatility and increase expected returns," professor Harvey says.

Harvey studied emerging market stock markets between 1976 and 1992. On average, emerging markets enjoyed an average annual return of 20.4 percent in dollar terms compared with only 13.6 percent in the United States.

True, emerging markets are far more volatile than markets in the U.S. The standard deviation (that is, how much the annual return is different from the long-term return) was 24.7 for emerging markets but only 15.2 in the United States.

But again, when both types of securities are in a portfolio, they tend to even each other out because there is little correlation between movements in emerging market countries and the U.S.

Bottom line: emerging markets can no longer be ignored. When held in combination with U.S. or other developed country securities, they will lower risk and boost returns.

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