The risk-return trade-off of emerging markets

The late President Thomas Jefferson once said, “With great risk comes great reward.” Well, in investing, higher risk is associated with a greater probability of higher returns but also a greater potential for higher losses. On the other hand, lower-risk investments are associated with a probability of lower returns and a lower risk of sustained losses. This trade-off that an investor faces between risk and return when making investment decisions is called the risk-return trade-off. One place where the risk-return trade-off requires careful consideration is emerging markets.

Investing in emerging markets can be a way to diversify portfolios containing US market and international developed market assets. Emerging markets are those countries that are still developing based on socioeconomic factors, including income levels, rule of law, economic stability, and more. There are emerging market countries across the globe, although we often focus on those in Asia, Latin America, and Eastern Europe. Emerging markets also include countries such as China, India, Brazil, Russia, and others.

Emerging markets may have higher returns (at higher risk)

When investing in emerging markets, you’ve left both your home turf and the safest international markets and should proceed carefully. Emerging market investments often behave differently than those of developed markets. This is because, in contrast to developed markets such as the US, Europe, and Japan, which have large and stable economies, emerging market countries are usually growing quickly to “catch up” to the developed world. While this has made them historically riskier – that is, there are much wider price swings for both emerging market stocks and indexes – they can have higher expected returns as well.

Investment opportunities in emerging markets

The significant economic growth of China and India are two great examples of the potential in emerging markets. Over the past two decades, both countries have created many volatile but attractive investment opportunities. Emerging market countries often have positive demographic trends, such as younger and growing populations, which drive economic demand and support a strong workforce. Additionally, some emerging market countries are important not just in manufacturing and natural resource industries, but in technology sectors as well. These growth trends can make emerging market investments attractive, especially as their economies continue to develop.

That’s why holding a well-diversified set of emerging market stocks across countries, via an exchange-traded fund (ETF) or mutual fund, can add further diversification to your portfolio. The chart below shows how much more cheaply valued emerging market stocks (dark-orange line) are compared to the US and developed market stocks, despite some potentially attractive long-term characteristics.

The left axis of the chart below shows the price-to-earnings (P/E) ratio, a metric that measures whether investments in a region are expensive or cheap relative to the earnings of the companies that make up that region’s stock market. The numbers (which are followed by an X) along the right axis represent the price-to-earnings multiple for each market. You’ll see that emerging markets have a P/E multiple of 10.9X while the US has a P/E multiple of 16.9X.

The P/E multiple is used to show the relationship between market value (price) and earnings. A low P/E multiple means the market is trading at a price that is considered low for its overall earnings/valuation. In other words, it means that investing in that market could provide a good value for investors! When the P/E multiple is high, it means that the price investors would have to pay for those investments is high compared to the actual earnings. Bottom line: The lower the P/E multiple, the more undervalued the market and the more opportunities there may be for finding investment opportunities! Kinda like getting a great deal on a house in an up-and-coming neighborhood.

P/E ratios across regions

Source: Clearnomics, Thomson Reuters, Standard & Poor's, MSCI

Not all emerging markets are equal

There are some markets that are even earlier on the development scale than emerging markets. These are often referred to as “frontier markets,” and can include countries such as Vietnam, Kuwait, Argentina, Morocco, and others. Because many frontier markets do not have established stock markets, investments in these countries are often made privately, and investors must accept high risk.

In addition to risks related to financial markets, other risks that come with both emerging and frontier markets include geopolitical risks as well as currency risks, both of which are more common in less economically developed nations than in the US or developed markets. These risks could significantly affect the value of investments in these regions, increasing the volatility and potential for loss. Buyer beware.

Emerging markets add another layer of diversification

It’s clear that there are advantages to holding all types of investments in your portfolio. International and emerging markets offer a significant opportunity to diversify even further! You’re not just helping to further limit volatility, you’re increasing your return potential when you step outside of your comfort zone and invest internationally. However, these markets can present some substantial risks when you invest in them on their own. Be cautious and invest on, folks!