Pros and Cons of Investing in Emerging Markets: A Comprehensive Analysis
Introduction
In recent years, investing in emerging markets has gained significant traction among investors seeking diversification and higher returns. However, this strategy also entails considerable risks. This article delves into the advantages and disadvantages of investing in emerging markets, providing a comprehensive analysis to help investors make informed decisions.
The Greatest Pro: Current Valuation Levels
Current Valuation
One of the most compelling reasons to consider investing in emerging markets is the current valuation levels. Emerging markets and, in some cases, European markets are trading at levels that the US stock market has experienced only twice in the past three decades. This relative cheapness suggests that these markets have the potential to outperform in the long term.
While some markets may have hit record highs, their price-to-earnings (P/E) and cyclically adjusted price-to-earnings (CAPE) ratios indicate that they are undervalued. Historically, undervalued markets have been able to outperform in the long run. This is a trend that has occurred during the early and mid-2000s, and it is beginning to play out again in 2020 and beyond.
The Biggest Negative: Increased Risk for Lower Returns
Increased Risk
Despite the potential for higher returns, investing in emerging markets comes with a higher level of financial risk and volatility. It is a common misconception that emerging markets always outperform developed markets, and this is not the case in the long term. Developed markets have consistently provided higher total returns over extended periods.
Moreover, political and social risks are more pronounced in emerging markets. These risks can significantly impact equity markets, leading to wider fluctuations. While US stock markets may be more resilient to political uncertainty, many frontier markets can experience sharp declines during times of political instability.
Risks and Diversification
Risks Included
Investing in emerging markets involves various risks, such as currency risks, political uncertainty, and social unrest. These risks can potentially lead to lower returns and increased volatility. For example, currency fluctuations can erode the value of investments, and political uncertainty can affect market stability.
However, it is important to note that these risks do not always correlate with higher returns. Sometimes, taking more risk does not necessarily result in higher rewards. This misconception can lead to unbalanced investment strategies that are more prone to volatility.
The Market’s Perception
The idea that emerging markets are always a better investment is a common misconception. The reality is that markets are efficient, and if investing in emerging markets was so clearly beneficial, everyone would be doing it. The temporary undervaluation of these markets is often a result of the perceived or real higher risks involved.
Investors tend to become more interested in emerging markets when they are performing well, which can lead to suboptimal investment decisions. Many fail to buy and hold these assets, and the high volatility compared to developed markets often deters investors from pursuing this strategy.
Diversification through MSCI World
Diversification Strategy
Given the risks involved, a more strategic approach can be to gain exposure to emerging markets through broader indices, such as the MSCI World index. This index provides a diversified portfolio of developed and emerging markets, reducing the concentration risk associated with individual emerging market countries.
The MSCI World index offers a balanced portfolio that can provide consistent returns without the extreme volatility often seen in single country investments. This strategy can help investors achieve their diversification goals while mitigating some of the risks associated with emerging markets.
Conclusion
In conclusion, while investing in emerging markets can offer diversification and the potential for higher returns, it is important to be aware of the associated risks. The current undervaluation of emerging markets provides an opportunity for long-term gains, but investors should be prepared for increased financial risk and volatility. A well-researched and diversified strategy, such as investing in the MSCI World index, can help maximize the benefits of emerging markets while minimizing the downsides.