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Emerging Markets Investing

Emerging markets investing refers to investing in the less-developed countries of the world. These countries typically have economies and capital markets that are less-developed. But because they are poorer their economies have potential to grow faster and therefore their markets can give you a higher return. Buying into a certain asset class based on its long-term economic characteristics is what traders refer to as a "macro trade" (or "macroeconomic trade").

Emerging markets investing has become much more popular over the last 10 to 20 years. One of the reasons is due to the various academic studies released that point out that allocating some of your portfolio's money to the higher returns of the emerging markets can boost your portfolio's returns while the diversification can actually lower the risk of your overall portfolio at the same time. Another reason for the increase in popularity of emerging markets is the creation of different investment vehicles - like foreign mutual funds - that allow everyday investors to have access to these markets.

The risks

Emerging markets are one of the most misunderstood areas of investing. This is because the risks that are present in these markets aren't present in first-world markets so most investors just assume them away. Here are some of the risks associated with emerging markets:

  • Political risk - Political instability can cause investors to move their money to more stable environments.

  • Currency risk - Not only are you exposed to currency fluctuations but you are also exposed to a currency-related crisis like the Mexican, Asian, or Russian crisis in the 1990's.

  • Economic risk - Many of these countries have economies that are very concentrated in certain industries, like oil or other commodities. Another example is that many times these countries donít have the basic infrastructure necessary for economic growth.

  • Liquidity risk - There are some markets that simply do not have enough buyers and sellers. When Long-Term Capital Management lost billions during their meltdown some of it was due to the fact that they had a sizable position in the Russian bond market, which was not a very big market. When the market dropped there weren't enough buyers.

  • Information risk - There is a lot less information when it comes to foreign companies.

Tough times

The 1990's were a particularly rocky time for emerging markets investors. Losses suffered during the Mexican peso devaluation of 1994, Russian financial crisis of 1997, and Asian financial crisis of 1998 left many investors disenchanted and bitter. These losses were compounded by the fact that the US and European stock markets were rising sharply throughout the decade.

One problem is that investors in emerging markets need a longer-than-usual time-frame (sometimes decades) in order to be confident that their investments will pay off. But many emerging market investors get into the market looking for quick gains. This happened in 2003 when many investors bought into Chinese internet companies and ended up getting disappointed. Countries like China should be looked at the way the US was in the 1920's. Getting into the US stock market in 1920 would have led to a 10-fold increase if held for 40 years but there was also an 80% drop in the market during that time. There will be times when the Chinese stock market will drop 50% to 80% in a year. More precisely, the Chinese stock market should drop that much at some point in the future considering it's characteristics of fast growth and an immature economy.

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