Don’t let the potential rewards distract you from the risks of investing in emerging markets, or you could watch any profits disappear.
There’s a small North American bird that can teach us a lot about the risks of investing in emerging markets. The killdeer is a brown and white bird, known for its striking black bands around the eyes and upper chest. What’s particularly interesting about the killdeer, though, is the way it reacts to predators.
The killdeer nests and lays its eggs on open ground, such as fields, golf courses, or even gravel parking lots. Obviously, this leaves any eggs or young chicks quite vulnerable. To defend the nest, if predators approach, the killdeer will run and feign a broken wing, distracting and drawing the predator away from the nest. Of course, this leaves the nest entirely vulnerable. It’s a risk vs. reward calculation, which is what we do when we invest, albeit without faking broken limbs.
The lesson, however, is that it’s imperative that we are aware of the risks when we invest. And even though emerging markets offer potentially substantial rewards, we can’t let those distract us from the downsides.
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The rewards of investing in emerging markets
Investments in emerging markets do come with a lot of promise, and there are plenty of good reasons to hold emerging market stocks in your portfolio. These economies tend to grow faster than the economies of developed countries, and are thus fertile ground for fast-growing companies and investments.
Emerging markets aren’t all speculative, either. Emerging market blue-chip stocks have the same talented management and steady dividends that traditional blue chips offer, plus they’re often growing quickly.
The risks of investing in emerging markets
No smart investor would look at the potential gains without taking into account the risk of any investment. That’s why, despite the potential for massive rewards, you can’t ignore the risks of investing in emerging markets.
Many emerging markets are plagued by political instability, inferior infrastructure, volatile currencies, and limited equity opportunities. In addition, some of the largest companies in emerging markets are either state-run or private. There are simply more unknowns when investing in a market that is still developing. And the less you know about a company, the more risk you take on when you invest in it.
As a whole, these stocks can be highly volatile. From 2004 to 2008, emerging markets were up 215%, measured in U.S. dollars. During and right after the global financial crisis, emerging markets fell sharply but then gained it all back just as quickly.
Then they fell again: from 2011 to 2015 they were down 40%. After a 50% surge in 2016 and 2017, debt issues in Argentina and Turkey, a stronger dollar, and trade tension between the U.S. and China all fueled a 2018 pullback of 18%. On and on the story goes.
In fact, in 2019, Argentina’s stock market fell by an astounding 48% in a single day. And that was after record-breaking highs just two weeks prior.
Then there are individual stocks that can lure you with seemingly incredible growth, only to pull the profits out from under you faster than you can say, “What happened?” Luckin Coffee (LK) is one such story.
This Chinese company purportedly ended 2019 with 4,500 coffee outlets in China, a number larger than Starbucks. Luckin came public in May 2019, and the stock was up 157% by the following January, peaking at 51. And then the bottom fell out of the stock on April 2, after the company announced that it had suspended COO Jan Liu and several employees reporting to him for misconduct related to “fabricated transactions.”
This isn’t to push you away from emerging markets altogether. There truly are some fantastic opportunities. But you have to be aware of the risks of investing in emerging markets; you never want to invest without weighing the reality of what you’re getting into.
And though you can never eliminate risk in the stock market, you can limit it. In the case of emerging market stocks, you can stick to American Depository Receipts (ADRs), which trade on U.S. exchanges, and subjects the stocks to strict U.S. requirements.
What is your opinion on investing in emerging markets? Is the reward worth the risk? Share your thoughts in the comments below.