When it comes to investment, households sometimes stick with what they know. It might mean primarily buying assets in their own country rather than trying to spread the risk of their portfolio or seek higher returns by diversifying into other geographic areas – such as emerging markets.
But the very fact that emerging markets are unfamiliar can be a challenge for investors, who call fall into the “availability bias” and other thinking traps.
Despite their rising profile, there is no one, single definition of an emerging market. Investment firms and economists divide countries into advanced economies (such as The Netherlands), emerging ones (such as India) and developing countries (much of Africa). The World Bank lists country lending groups. Investopedia writes that the term was first coined in 1981. Warton writes that in those early years, the definition applied to countries with an annual income of $10,000 or less per person but more modern definitions refer to the strength of a country’s economic and political institutions. Countries have varying levels of legal protection for investors as well as being at different stages of economic development.
Looks can be deceiving
ING Group chief economist Mark Cliffe says in his tenth video lesson from the financial crisis that investors can no longer ignore emerging markets.
In the decade to the end of February 2014, emerging markets as defined by the share market monitoring group MSCI increased at an annualised rate of 7.3% while developed markets rose by 4.6%. For the five years to the end of February 2014, emerging markets recorded an annualised return of 14.1% while developed markets rose by 17.4%.
These emerging market figures might look very attractive but before diving in it might pay to pause and take a look at the wider picture. The availability bias describes the way commonly available information can spring to mind and play a greater role in decisions than is actually warranted.
For emerging markets, perhaps try to allay availability bias by putting more context around these headline grabbing returns. In particular, consider the volatility and risk associated with these returns.
Times, they are a-changing
If emerging markets can offer high returns, be aware they will likely have a risk profile to match. For example, the extra returns commonly expected from investing in emerging markets over long periods may not occur.
Note how the returns on emerging markets in the five years to February 2014 (shown above) are lower than for developed markets, but still higher on a ten year basis. It is often recognised by investment professionals that investments in emerging markets may be exposed to risks of higher inflation, exchange rate fluctuations, adverse repatriation laws and economic and political distress. But this 2010 paper suggests, many emerging economies have started to show evidence that they are running their economics in similar ways to advanced economies.
Taken together these trends have led analysts to create new groupings of emerging economies. This includes the BRICs group of Brazil, Russia, India and China coined in 2001. Others are CIVETS (Colombia, Indonesia, Vietnam, Egypt, Turkey, South Africa), MAVINS (Mexico, Australia, Vietnam, Indonesia, Nigeria, South Africa) and EAGLES (Emerging and Growth-Leading Economies - BRIC plus Korea, Indonesia, Mexico, Turkey, Egypt, Taiwan) and MINT (Mexico Indonesia, Nigeria and Turkey).
While this can help investors decide which emerging markets they might choose to invest in, investment decisions should not be based solely on broad categories.
Anyone putting their hard-earned money into an investment must ensure they know where their cash is going and who will be managing it. It is also important they understand the risks involved and decide whether that level of risk fits with their own financial profile.
This eZonomics blogpost by economist Chris Dillow gives a guide on how people can divide their investments between safe and risky assets.