If you look at the 10 year performance of Emerging Markets and compare that to the 10 year performance of the S&P you might think it would be crazy to be invested in the U.S. market. However, when you look a bit closer you will see that even though emerging markets out-perform on the upside they also get hit much harder on the down side when a crisis comes along.
Had you invested in the first Emerging Markets ETF (EEM) on the first day of trading in 2003 you would’ve experienced a 350% gain in the first 5 1/2 years but then you would’ve lost over 85% of that gain the following year during the credit crunch. So despite the fact that emerging markets tend to strongly out-perform developed markets during good times, you may not want to have all your eggs in that basket.
Why such volatility? It’s because there are two strong dynamics at work. First, emerging markets have a tremendous amount of growth potential and since their economies are small they can grow fast when the conditions are favorable. This is also true for small cap stocks, it’s much easier for a $10 Million company to double in size than a $100 Billion company to double. However, when times are challenging, such as during the world wide credit crunch, the odds of small emerging countries (& small companies) failing is much higher than a developed country. When you combine the enormous growth potential with a high degree of risk, result is a very volatile asset.
This is one reason why ETFs have become so popular. It allows you to invest in an entire country or basket of countries with a single stock purchase, diversifying your risk. When looking at the emerging markets you will want to look at the various ETF choices and see how their past performance compare to each other. Look at how they performed in 2008 as well as how they did in the good times. In the end, you will want to allocate a percentage of your portfolio to this area of investing but be careful not to take on too much risk. The goal is to make a good return over time while still being able to sleep well at night.
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