EC How Much Should We Invest In Emerging Markets – Burton Malkiel

How Much Should We Invest In Emerging Markets - Burton Malkiel

One of the most enduring and perplexing behavioral biases in investing is called “The Home Country Bias.” Despite the availability of well-regarded and highly profitable corporations located through the world, investors have tended to limit their investments to companies domiciled in their own country. At one time, a survey of institutional investors in France found that 97 percent of their equity investments consisted of French companies despite the fact that France represented only 3 percent of the world’s total equity capitalization. There is a strong tendency for investors to regard international stocks as risky, and this is especially the case when it comes to emerging markets.

Emerging markets do indeed present additional risks, but they are less risky than they used to be. Many investors still remember the dramatic crisis in 1998, and the terrible losses suffered by equity investors as P/E multiples compressed to low single-digit levels. I certainly remember it; in fact, I co-authored a book on emerging markets that year called “Global Bargain Hunting.” Investors hoping for a repeat episode of 1998 are likely to be disappointed, however. A lot of corrective action was taken by governments everywhere at the time, and their economies and capital markets have progressed a great deal since then. A similar crisis is unlikely today.

While most investors are aware that these markets are growing, few realize just how large they have already become. It also pays to remember that, within a global stock portfolio, the diversification benefits of adding emerging markets could actually reduce your overall risk. More importantly, I think it will improve your returns in the years ahead: valuations are considerably lower than they are in developed markets, and combined with higher economic growth rates, emerging markets are very likely to outperform over the next decade.

This low valuation/high growth dynamic should also provide a decent cushion against any downside volatility, or worse, a crash in global share prices. Interestingly, there is even a proven strategy available today that converts this volatility into an advantage for investors. That strategy is described in the last section of this paper.

How large are emerging markets?

If we are to arrive at some reasonable judgment regarding the appropriate exposure of an investment portfolio to emerging markets, it is important to understand their size and importance to the world economy. The table below presents the total market capitalization of the various regions of the world. Note that the United States represents only 36.2 percent of the world’s market capitalization. Emerging markets represent 24.6 percent. Thus, if an investor wishes to hold a global portfolio weighted by market capitalization, almost one quarter of that portfolio would consist of emerging market equities.

Burton Malkiel

Burton Malkiel

Another metric that might be used to judge the appropriateness of an emerging markets equity allocation is to examine their share of world GDP. Inter-country comparisons can be tricky, requiring exchange rate and purchasing power parity adjustments. In one estimate made by the International Monetary Fund, emerging markets have already exceeded the GDP of the developed market countries as is shown in Figure 1 below.

According to the World Bank, by 2020 both China and India will have GDPs exceeding that of the United States.

The World Bank reduced its growth forecasts for the global economy in its January 2015 report summarized in Figure 3. But it noted increasingly divergent trends. The Bank remains pessimistic about the prospect for the developed world but more optimistic about the emerging economies. While growth has slowed in the developing world, the growth prospects for emerging-market economies remain substantially higher than those for the more mature economies. A major reason for the divergence is the substantial differences in demographies.

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