Why Now May Be the Time to Invest in Emerging Markets

Emerging markets — the capital markets of underdeveloped nations — were undeniably a poor investment in 2011. The MSCI (a highly regarded index of emerging-market stocks) was down 18 percent for the year.

But one person's time to sell is another's opportunity to invest. Because these investments are now far less expensive, there's more potential upside, assuming that growth occurs. And, almost without exception, long-term forecasts for these investments call for growth.

Of course, you must first decide whether you want to include emerging markets in your portfolio. Emerging markets are those in countries with relatively low per capita income and stock markets that are less developed than those in wealthier nations. They represent about 80 percent of the world's population and 20 percent of the global economy.

These investments have posted impressive long-term growth on average, but they can fall as suddenly as they can rise. The up-and-down potential, or volatility, of emerging markets is much higher than in markets in the U.S. or in highly developed foreign countries.

Compared with U.S. stocks, this volatility in recent years has been striking. For example, in 2008, the MSCI declined 53 percent. In 2009, it shot up 79 percent. Investments in some countries naturally did better — or worse — than others. The Dow Jones Global Total Stock Market Index shows that Cyprus brought up the rear last year in stock and bond performance combined with a decline of 72 percent.

Despite the higher risk that this volatility brings, there's a good reason why even skittish investors might want to own a small amount of these investments: to vary their portfolios. The prices of emerging-market investments don't tend to rise and fall in lockstep with those of investments in the markets of more developed nations.

So adding a pinch of them to your portfolio can be a good defensive move. And in good years, emerging markets tend to pay better dividends than other markets — a highly desirable quality for any stock.

Many economists believe that emerging nations' markets will experience robust economic growth over the next 30 years, driving up prices on investments in their companies. Economic growth in these countries has been brisk in recent years, and many believe that this will continue at a pace similar to what the U.S. experienced in the 20th century, giving rise to a middle class that consumes goods, propelling growth and driving up investment values.

A sub-category of emerging-market countries is known as frontier markets — the least developed economies among them. Examples include Vietnam, Pakistan and Argentina, which are far less developed than their respective emerging-market neighbors, China, India and Brazil. Russia is still considered to be an emerging market, while Bulgaria and Croatia are still frontier. Most Middle Eastern nations are frontier, largely because their stock markets are not well developed.

Investing in the markets of frontier nations tends to have greater potential returns than doing so in more developed emerging markets, but usually more risk. Regardless of how much risk you can handle, you face the issue of when to get in and when to get out of a given market. Unlike some other portfolios, success in emerging-market investing doesn't tend to come from long-term, buy-and-hold investing.

Although emerging markets are expected to rise in the coming decades, this will be a jagged line on the chart. Investments in different nations carry different risk levels, and choosing the wrong country to concentrate on can prove dangerous.

There's also the issue of whether to invest actively by buying and selling investments directly or to invest passively by buying shares in emerging-market mutual funds or exchange-traded funds (ETFs) managed by professionals. If you have the skills and knowledge to buy and sell wisely, then you may be able to avoid steep dips.

Using well-managed funds can expose you to dips but can moderate your losses. Also, you don't have to constantly monitor the often murky economic developments in nations where unstable governments (known as political risk) can threaten economic growth and sink your investments.

Whatever route you choose, you should consider using an advisor who's an expert in this highly complex and fluid investment area. And, as always, strive to exorcise the twin investing devils of fear and greed, which can lead you to buy high and sell low, wiping out gains.

Ted Schwartz, a Certified Financial Planner®, is president and chief investment officer of Capstone Investment Financial Group. He advises individual investors and endowments, and serves as the advisor to CIFG Funds. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation when advising clients on achieving their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at ted@capstoneinvest.com.