Exotic Markets Survival Guide (from the WSJ)

Just yesterday, I blogged about an article in the weekend Wall Street Journal on the "Three Fund Investment Strategy" (i.e. construct a portfolio consisting of three assets: a domestic stock index fund, a domestic bond fund, and an international stock fund).

So, to follow that up, I thought I'd highlight a second piece from the Journal, on investing in emerging markets. It's titled "Exotic Markets Survival Guide", and is also from the Saturday Journal. Here's a snippet:

As more Americans invest abroad, the past year has served as a cautionary tale about the promise -- and risk -- of such a strategy. In May and June, emerging markets plunged amid worries over rising U.S. and Japanese interest rates and a possible global slowdown.

But within months, the markets rebounded. The MSCI Emerging Markets Index is up 23.7% in dollar terms this year -- just 1% away from its all-time high. The Dow Jones Industrial Average is up 14%.

Emerging markets have benefited from accelerated economic growth, large and youthful populations, and little-known but profitable companies. The category includes much of the world outside the U.S., western Europe, and Japan, encompassing countries as big as China and as small as the Czech Republic.

In the past, investors were wary of political upheaval, poor infrastructure, and shaky economic fundamentals that sometimes erupted into a full-blown financial crisis in such markets. Geopolitical risk still disquiets investors, who worry Middle East turmoil could spill over into Turkey, for example.

It's definitely worth reading the whole thing. Here are a few thoughts (in no particular order, like most of my thoughts:

• There's a huge variation in performance for the various individual emerging markets. Rather than try to pick winners, it's best to invest in a broad cross-section of markets-- ideally in an index fund or ETF.
• A good part of the performance in the last year is due to exchange-rate fluctuations. Whenever the dollar weakens, it increases the "US Dollar" returns relative to the returns in the emerging market's own currency. For example, MSCI index is up 20.9% in local currency terms, but has returned 23.7% in dollar terms.
• There are risks to investing in emerging markets (political risk, the risk that the emerging market's home economy will collapse, and so on. So, it's best to DIVERSIFY.

All in all, the piece is worth reading. I think most portfolios should have some exposure to international equities. Not surprisingly, stocks in emerging markets are less correlated with the U.S. index than are the typical U.S. stocks. So, adding them to a portfolio reduces portfolio risk. And they might even outperform the U.S. markets over time.