Emerging markets may look friendly, but watch out for teeth

— -- Let's say your neighbor has a dog named Sam. Nice dog. He'll wag his tail for you. Do tricks. Heck, he'll even fetch your paper.

Unfortunately, every few months, some distant memory of Sam's unhappy puppyhood returns, and he uses your tibia for a chew toy.

A sensible approach would be to avoid Sam altogether, or to approach him only when wearing stainless steel socks. Sam's adorableness, after all, doesn't make up for the pain of his bite.

Think of emerging-markets funds as a kind of financial dog with anger issues. Both are wonderful when they are good. But you should approach them very, very carefully. It's hard to make up for the pain they cause when they're bad.

Emerging markets are a bit of a misnomer. When most people think of emerging markets, they think of stock markets in new, impoverished nations where the main export is despair.

In fact, emerging markets are simply countries that aren't among the major developed countries, such as the United States, Japan and the Euro zone. MSCI Barra, which tracks returns from global stock markets, considers China, South Korea and Russia as emerging markets.

Right now, emerging markets look awfully tempting. MSCI Barra's Europe, Australasia and Far East index has gained 5.1% this year, in U.S. dollars. Its emerging-markets index has soared 33.3%.

Emerging markets have beaten developed markets for the past decade, too. EAFE has lost about 1% a year for the past 10 years; the emerging-markets index has gained 6.9% a year.

And emerging markets have great growth potential. India, for example, has about 392 million wireless phone subscribers, or about one cellphone subscription for every three people, according to the Telecom Regulatory Authority of India. Plenty of room to grow there: India added 15.6 million wireless phone subscribers in March alone.

In contrast, about 86% of the U.S. population own cellphones, says the Central Intelligence Agency. (And they know. Oh, yes, they do.) The U.S. market has room for replacement phones, but most emerging markets are far more ripe for growth among new users.

Emerging markets are also the world's storehouse of raw materials, ranging from oil to timber to gold. When worldwide demand for raw materials rises — as it does when the economy turns around — companies based in emerging markets should see their earnings soar.

So, what's not to like? A few things.

First, emerging markets tend to be less stable than developed markets, in part because they may be dependent on just a few industries — energy or mining, for example. And, while emerging markets are more stable today than they were during the global currency crisis in August 1998, they are still more prone to political and economic instability than developing markets.

Finally, emerging markets have price swings that make the U.S. market look like a bank CD. Consider the Lipper Emerging Markets Fund index. The past 10 years, its biggest three-month gain has been a 29% jump, scored in 2000. Its worst: a soul-searing 45% loss last year.

In contrast, the biggest three-month loss for the Standard & Poor's 500-stock index was a 23% plunge last year. Biggest three-month gain the past decade: 8.5%.

Most people love volatile markets — at least when the volatility drives the market up. Unfortunately, you pay for those big gains with the potential for big losses. And the longer you hold a highly volatile fund, the greater your chances of experiencing a catastrophic loss.

Not surprisingly, the risk of a big loss is often when an emerging-markets fund looks most tempting. (This is true in all stock funds, but remember, the losses tend to be bigger with emerging-markets funds.) If you're eyeing these funds' big gains, remember that big losses may not be far behind.

Still tempted by emerging-markets funds? Fine. Here are a few rules to keep yourself from getting bitten:

•Avoid single-country funds. India's stock market soared 17% this week on its election results. If you aren't from India, or an Indian expert, this probably startled you. If it did, you have no business investing in a fund that specializes in the Indian market.

•Don't go overboard. Having 5% to 10% of your stock portfolio in emerging markets is rational. More than that indicates masochistic tendencies.

•Rebalance. Let's say you target 10% of your portfolio for emerging markets. Two years later, it's a 20% stake. Call someone and gloat. Then sell half your holdings to get back to a 10% level. You'll limit gains, but you'll also rein in losses.

If you want a small stake in emerging markets, go ahead. Just make sure your portfolio doesn't get mauled.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. new book,Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. Click here for an index of Investing columns. His e-mail is jwaggoner@usatoday.com. Twitter: www.twitter.com/johnwaggoner.