Investing in Emerging Markets

A good friend recently told me that he has decided to place a substantial portion of his portfolio in index funds that specialize in the Chinese market, as well as two other funds that specialize in other emerging markets. When I pointed out that the Chinese stock market has seen dramatic returns recently and that there is serious talk of a bubble (see this excellent post by 1st Million), my friend pointed out that in previous discussions I said that timing the market is a bad idea. He got me there. I did say it, and I believe it.

So how do I reconcile my position against market timing with my belief that my friend's investment carries a substantial amount of unnecessary risk? Well, I don't think that there is really a conflict. In opinion, market timing is not a viable strategy. You shouldn't sit on the fence and wait for a crash before you invest, because you never really know whether a crash is coming. However, taking a sudden and large position in a market that has seen outsized returns for years is probably not advisable either. Regardless of what you tell yourself, such a move probably contains some element of performance chasing. Ask yourself, would I really make the same move if the market lost 20% in the past year?

I guess I should re-state my concern about my friend's investment strategy: it's not that I have a problem with emerging market investments at this specific point in time for fear of a bubble (although the market looks overly ebullient to me). Rather, I am concerned about the speed and magnitude of the move. If my friend took a gradual, dollar-cost-averaging approach to entering this risky investment, I would consider it a much better strategy.

So here is my personal opinion on investing in emerging markets:

1. Investing in emerging markets is a good thing, when done as a part of a broader, adequately diversified investment strategy. Emerging markets have a large potential for growth over the long run, and over such periods their stock markets are also likely to do well. In fact, I would bet that over the really long run, say 20 to 30 years, most emerging market equity markets will outperform U.S. equity markets.

2. Investing in emerging markets is extremely risky. If you are going to invest in emerging markets, make sure that you have the stomach to hold on to your investments even if you lose 50% or more in a single year. Remember the crises in Russia, Thailand and Argentina in the late 90's? Will you be able to hold onto your investments through declines of that magnitude? If you can't weather the down markets, find a less risky investment.

3. Investing in emerging markets is a long term proposition. If you plan to withdraw and spend your money in only a few years, this type of investment is not for you. If your investment horizon is not sufficient and you happen to be hit by one of the massive bear markets that emerging markets are notorious for, you might not be able to recover your losses.

4. Because of the risk profile I outlined above, move into the market slowly. There is nothing nastier than putting a large chunk of change in the market only to see much of it go up in smoke within a few days. If you want to get into the market, set a target time line of a year or so to complete your move, and complete it over a number of trades spaced a few months apart. That will give you some protection against sudden downwards shifts in the market.