Putting Emerging Market Stock Losses Into Perspective

“Volatility can be a good thing for investors; be prepared to benefit from it. [...] Political uncertainty – like any other form of uncertainty – can be your green light to move into a market.” – Mark Mobius


Emerging Markets have been getting all of the financial headlines lately. Currency issues and political instability have been hammering financial markets of the developing countries.

The Vanguard Emerging Markets ETF (VWO) is down nearly 10% this month after losing around 5% last year.  From the high price in 2011, VWO is down nearly 25% with a handful of individual countries performing much worse.

These performance numbers look even worse on a relative basis when compared to buoyant U.S. markets over the past year and change.

Following the financial crisis many thought the U.S. economy would never grow again (I’m only half kidding) and plowed money in emerging market countries because “that’s where the growth is” without considering the actual investment merits.

Predictably, the recent losses have triggered huge withdrawals from emerging market mutual funds and ETFs. According to Business Insider, there have now been 13 straight weeks of outflows from EM funds.

At times like these I like to keep a clear head and view the markets through a historical lens. Each situation will be different but it helps to know how these markets have acted in the past.

Since the inception of the MSCI Emerging Markets Index in 1988 through the end of 2013, EM stocks have returned nearly 1,900% or roughly 12.1% per year. Compare that with the nearly 1,200% gain or 10.4% a year in the S&P 500.

Ten thousand bucks invested in the EM index grew to almost $196,000 while you got around $130,000 in the S&P 500.

Sounds great, but you have to be an extremely aggressive and patient investor to be able to stomach the ups and downs in emerging market stocks.

I’m not a huge fan of volatility (standard deviation) as a risk measure, but I think it helps drive home the point on the difference between developed and emerging stock markets.

The annualized standard deviation of emerging market stocks from 1988 to 2013 was over 35% or nearly double the 18% volatility seen in the S&P 500.

In laymen’s terms, that means investors experienced bigger gains and bigger losses.

For example, in the same 1988 to 2013 timeline, the EM index had six calendar years of performance in excess of 50% including four years of gains over 60%. The S&P 500 returned just under 38% in its best year.

There were also six times that EM stocks finished the year with a loss of more than 10% (including losses of -10.6%, -11.6%, -25.3%, -30.6%, -53.2% & -18.2%). The S&P 500 only finished the year with a double digit loss on three occasions.

Another fact to consider is that these markets are extremely cyclical.

Think of emerging market stocks like small caps.  Historically they have outperformed, but they go through long periods of underperformance because the companies are not yet mature and investor appetites are always changing.

Take a look at this total return breakdown by four different periods:

EM stocks

There are clearly long stretches where one markets takes the lead.  Then things get overheated and the baton get passed to the underperforming market.

Do you know what they call it when you have investments in your portfolio that act differently depending changes in economic activity, investor sentiment, trend and valuation?

Why it’s our old friend diversification!

This is how diversified portfolios are supposed to work.  Some markets do better, some do worse and then mean reversion kicks in and they switch places.

A simple 75/25 mix of the S&P 500 and the EM Index would have earned you returns of 11.5% during this 26 year period with a standard deviation of less than 20%.

Of course, how much of your portfolio goes into EM stocks depends a great deal on your intestinal fortitude because it will be tested by the wild swings in price.

Emerging markets make up only about 8% of world stock market index funds and almost 15% of total international index funds, but account for around 40% of global GDP.

I would say a reasonable allocation would be in the 5-15% range. It really comes down to personal preference, risk tolerance and time horizon.

If you need to use the money within the next couple of years then emerging markets are far too risky because things could get worse before they get better.

Just don’t pay attention to the talking heads as they try to make sense of what’s happening in complex financial and economic markets that are still finding their way.

Emerging market stocks are cheap when compared to developed stocks in the U.S. and around the globe and they could definitely get cheaper. But investors who think in terms of decades have been rewarded by buying into markets that are beaten down and unloved with low valuations.

I wish I could tell you exactly when to buy into these stocks. In the absence of a crystal ball, my advice would be to dollar cost average or rebalance periodically over a set time frame.

It’s not a perfect plan, but it should serve you better than listening to the “experts” who will tell you to wait until things get better.

You could try to use your macroeconomic Ouija board to guess when things are going to turn around, but no one really knows.

Unfortunately, the coast in never clear when investing in risky assets. If you are a long-term investor you shouldn’t worry about perfect timing, only a consistent process.

I’m probably early here but they say value investing is when everyone agrees with you later.

Further Reading:
Why aren’t investors snapping up cheap, battered emerging markets? (Michael Santoli)
7 reasons to buy emerging market stocks (Brett Arends)

Now here’s the best stuff I’ve been reading this week:

  • Subscribe to the Common Sense monthly newsletter:

Follow me on Twitter: @awealthofcs

Share Button

18 thoughts on “Putting Emerging Market Stock Losses Into Perspective

  1. AWOCS,
    Informative piece here. I’ve been looking at the VWO for my retirement accounts. This is helpful. I haven’t done enough research yet, but that table is really eye opening… maybe a little jaw dropping.
    -RBD

    • Hard to believe when it seems like every market is so correlated these days. Those long periods of underperformance make it really difficult for investors to hang on though.

  2. Pingback: Hot Links: One Foot Out The Door | The Reformed Broker

  3. Pingback: 10 Friday AM Reads | The Big Picture

  4. Pingback: Friday links: serious modeling | Abnormal Returns

  5. Hey Ben, this article really magnifies the volatility that investors in emerging markets face. How much of your portfolio have you allocated to EM funds? Personally, I’m tracking it a lot more closely now that it’s been “beaten down and unloved”.

    • Right, it can definitely be feast or famine investing in EM stocks. Many people jumped in without realizing that they can have large losses in addition to the large gains.

  6. Pingback: Friday Afternoon Reads: Emerging Markets | Writings on Wall St

  7. Pingback: Weekend reading: emerging markets, mistakes in college, and more | AAFS Insurance

  8. Pingback: Happy Hour: The Redundant MyRA • Novel Investor

  9. Hi Ben. Thanks for the post. You might find this interesting. For each year in the 2003-2013 period, EM was either in the top quartile of asset class performance or in the bottom quartile. Never the middle 50%, so the volatility is truly astounding. Also, 2009 was the last year EM performed above its historical median (2003-2013). My latest blog post digs deeper into these observations. Thanks again, Dave.

    • That is interesting. I put up an asset allocation quilt a few weeks ago and noticed the highs and lows but didn’t realize EM stocks were never in the middle. Higher highs and lower lows indeed.

      I think the nature of the growth in GDP has something to do with it and they get bid up way too high only to get hammered on any hint of weakness. And both ways it goes to far.

  10. EM investments sure can be volatile but before you invest any money there you should be aware of that. Despite what 2013 in the US showed us, markets don’t go straight up. They wax and wane and move in cycles. If you’re going with a broad index approach, then just set an allocation you’re comfortable with and check up on it every now and then to see if you should rebalance. Investing isn’t difficult once you find a way to get yourself out of your own way.

    And thanks for the link to my post.

  11. Pingback: 361 Capital Weekly Research Briefing | The Reformed Broker

  12. Pingback: Emerging Markets: Here Come the Bulls | The Reformed Broker

  13. Pingback: 'Growth is Slowing' is Not a Valid Reason to Dump Emerging Market Stocks - A Wealth of Common Sense

  14. Pingback: Emerging Markets Move Fast | A Wealth of Common SenseA Wealth of Common Sense

  15. Pingback: The Best & Worst Part About Investing in Emerging Markets - A Wealth of Common SenseA Wealth of Common Sense

Leave a Reply

Your email address will not be published. Required fields are marked *


*

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>