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Proceed with Caution

Adam M. Grossman  |  June 7, 2018

MY FRIEND Rostislavwho would know, tells me that in Russian there’s no equivalent for the word “privacy.” That’s because privacy—as we understand it—is a foreign concept. Children’s grades are posted publicly in schools and it isn’t considered impolite to ask someone’s salary.

Why is this relevant? As a stock market investor, if you have international exposure, you’ll want to be aware of these cultural differences, because they impact how other countries run their economies and how they regulate—or don’t regulate—their investment markets. This is especially true for emerging markets such as Russia, Brazil, India, China and Indonesia.

The differences fall into several categories. Insider trading rules, for example, vary widely around the world. Even where it’s prohibited, many countries simply don’t prioritize enforcement. Rules governing public companies also differ, especially when it comes to requirements for financial audits. Legal systems differ as well, resulting in varying levels of contract enforcement, copyright protection and overall shareholder protection.

In the most extreme cases, governments have forcibly taken over private companies. Last year, for example, the Indonesian government succeeded in forcing U.S. company Freeport-McMoRan to turn over its crown jewel: majority ownership in the world’s largest gold mine, which is located in Indonesia. From the Indonesian government’s perspective, it was simply doing what it thought was best for its people. But it certainly wasn’t good for Freeport’s shareholders.

It isn’t my intention to pass judgment on other countries’ norms. Sometimes other countries’ approaches have benefited investors. In Japan, the Ministry of International Trade and Industry, which Americans have tended to view as heavy-handed, helped drive enviable industrial growth in the years following the Second World War.

Moreover, despite the cultural differences, investments in emerging market stocks have been profitable over time. Still, the data clearly indicate that, on average, emerging markets carry greater risk than domestic investments. In 2008, when U.S. stocks declined 37%, Russia’s market plunged nearly 74%. That wasn’t the first time we’ve seen such large performance gaps—and I doubt it will be the last.

Plan to invest in emerging markets? Here’s how I would balance risk and reward:

First, keep your investment modest. While I believe it’s worthwhile to invest in emerging markets, I would limit a stock portfolio’s exposure to no more than 10%, even if you consider yourself an aggressive investor. This is perhaps more art than science. But the logic is this: Own enough for it to make a difference, but not so much that it would cause you to lose sleep.

Second, diversify broadly. Don’t place bets on individual regions, countries or companies. Instead, to dampen volatility, I’d opt for a fund that includes all the emerging market countries, such as Vanguard’s VWO, Schwab’s SCHE or iShares’s IEMG. (Be careful to avoid iShares’s EEM, which is a similar fund but nearly five times more expensive than IEMG.)

To understand why, consider 2008, when Russia’s market sank 74%. In that year, emerging markets as a group held up much better, down “just” 53%. You wouldn’t have been happy with that performance—but if you hadn’t been diversified, you might have been far less happy.

Third, beware the myth that robust economic growth means robust stock returns. This may seem like a logical assumption. But according to a study by Elroy Dimson, Paul Marsh and Mike Staunton, there’s no conclusive correlation between economic growth and investment returns. In fact, some studies have found a slightly negative correlation. Over the past 10 years, for instance, the stock market in sleepy Denmark has far outpaced the market in fast-growing China.

Finally, don’t buy emerging market bonds. Instead, stick with stocks. In my view, the fixed-income portion of a portfolio is there primarily to provide stability, not to make money. While emerging market bonds may offer higher yields than U.S. bonds, they also carry greater risk of loss. According to one analysis, between 1999 and 2015, 12 different emerging market governments defaulted on their bonds 17 times—about once a year, on average.

Adam M. Grossman’s previous blogs include Old StorySlipping Away and All Thumbs. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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