If you're tired of watching stocks sputter in Canada and the United States, there are places to go where the sun shines brighter and profit opportunities loom larger. These promised lands are known as the emerging markets.
Of course, as with all promised lands, there are some catches. For starters, it helps if you're the type of person who likes to swan dive out of planes for chuckles and tickle cobras as a party trick. Just think of the messes you're buying into: Mexico's narco-corruption, Brazil's political dysfunction and Russia's unpredictable oil-fuelled autocracy headline the cavalcade of emerging-market chaos.
But, hey, stocks in these and other up-and-coming economies are cheap–dirt cheap. As a result, they seem primed to produce much better results than shares in more placid locales if you're prepared to hold them for several years.
The number crunchers at Research Affiliates LLC, quantitative investor Rob Arnott's market analysis firm, argue that currencies of developing nations have been this cheap only once before: in 1998, after the Asian currency crisis kneecapped emerging markets. Better yet, valuations of stocks in those countries have rarely been as low as they are now, especially in comparison to their U.S. counterparts.
The folks at GMO LLC concur. The Boston-based money manager, renowned for its quantitative rigour, says that stocks in the U.S., Canada and other developed nations are now so expensive they are likely to generate only miserable returns over the next few years.
In contrast, shares in emerging markets look like one of the few investments that can generate a decent profit. They are likely to produce average annual returns of 4 per cent after inflation between now and 2023 (see the chart below).
The math is compelling and the strategy is easy to implement. You can buy wide exposure to emerging markets at very reasonable cost through exchange-traded funds like the Vanguard FTSE Emerging Markets All Cap Index ETF (VEE) or the iShares MSCI Emerging Markets Index ETF (XEM).
But how much money should you devote to the notion? The answer depends more on psychology than economics. As tempting as the quantitative case for emerging markets may be in theory, the mental stress of being heavily invested in these countries is enormous. More days than not, you'll be confronted by disturbing reports of demonstrations, leadership purges and scandals somewhere in the developing world. At the risk of sounding like a pharmaceutical ad, the side effects of holding emerging-markets stocks include sleepless nights, dry mouth and gastric distress.
Wise investors know that the price of a stock in dollars and cents is just part of the total cost. There's also the psychological expenditure to consider, because no portfolio strategy works if you can't stick to it.
Behavioural finance researchers say we typically feel losses about twice as intensely as we experience gains. Given the tendency of emerging markets to spend substantial periods in the dumps, the human tendency to feel downs more vividly than ups means that a big tilt toward the developing world in your portfolio is nearly certain to be a grinding and dispiriting experience.
Hence, a modest suggestion: By all means, invest in the emerging markets, but think realistically about how much of your money you want to risk – then halve that target amount. Chances are it will generate all the stress you can handle on the way to some impressive long-term gains.
Ian McGugan