There’s a peculiar behavioral bias among investors called "the home country bias." With thousands of viable, highly-profitable corporations around the world, investors still predominately tend to limit their investments to companies headquartered in their own homelands. For example, an oft-referenced survey of institutional investors in France once found that 97 percent of their equity investments consist of French companies, despite the fact that France represents only 3 percent of the world's total equity capitalization. There is a strong tendency for investors, retail and institutional alike, to regard international stocks as risky and this phenomenon is especially pronounced when it comes to emerging markets.
It’s not difficult to understand why. Emerging markets do indeed present additional risks to investors, but less so than ever before. Many investors still remember the dramatic crisis in 1998, and the terrible losses suffered by equity investors as P/E multiples compressed to low single-digit levels. I certainly remember it well myself. (In fact, I co-authored a book on emerging markets that year called Global Bargain Hunting.) Investors expecting a repeat episode of 1998 should keep their expectations managed, however. A lot of corrective action was taken by governments worldwide at the time and their economies and capital markets have progressed a great deal since then. Thankfully, a similar crisis is unlikely today.
While most investors are aware that emerging markets are growing, few realize just how large they have already become. In examining global dispersions, regardless of whether one is measuring market capitalization, GDP or simple population demographics, the conclusions remain the same: Emerging markets have arrived as an influential factor on the global economic stage.
It’s also important to remember that, within a global stock portfolio, the diversification benefits of adding emerging markets could actually reduce one’s overall risk. More importantly, I think it will improve one’s returns in the years ahead: Valuations are considerably lower than they are in developed markets and, combined with higher economic growth rates, emerging markets are very likely to outperform over the course of the next decade.
This low-valuation/high-growth dynamic has the potential to provide a decent cushion against any downside volatility, or worse, a crash in global share prices. Interestingly, there is even a proven strategy available today which converts this volatility into an advantage for investors.
Since more volatility means higher options premiums, a strategy of selling index call options against a long portfolio is particularly useful in emerging markets. The strategy has worked well in the United States over long time periods, producing essentially market returns with a one-third reduction in volatility. It is even more effective in more volatile markets because of the generous premiums. In effect, this “buy-write” strategy sells insurance in a risky market which pays very well for this protection (whether it is upside or downside protection, i.e., calls or puts).
Emerging markets represent an increasingly substantial share of the total capitalization of world equity markets. While generally involving additional risk, these stock markets can also reflect relatively attractive valuations. In the context of the true size of their global economic impact, a weight of at least 10-15 percent of a portfolio in emerging market equities is appropriate for investors who are able to tolerate some risk and who have long enough investment horizons to ride out the inevitable ups and downs. While such an allocation is higher than that recommended by investment advisors, I believe that a home country bias has led to their under-representation in most globally diversified investment portfolios.
Dr. Burton Malkiel is the chairman of the sub-advisor of USA Mutuals / WaveFront Hedged Emerging Markets Fund (WAVFX), author of A Random Walk Down Wall Street and a founding director of The Vanguard Group.