There’s a strong case for having at least a benchmark exposure to emerging market (EM) investments, as my colleague Heidi Richardson recently pointed out.
However, despite EM stocks’ attractive valuations and the numerous other reasons to like select EM equities and bonds, many investors continue to underweight the emerging world in their portfolios. To be sure, investor concerns over rising rates and global growth are partly to blame and have been contributing to EM fund outflows lately.
However, behavioral finance theories can also explain why many investors tend to shun EM investments. In fact, I see three psychological barriers keeping many investors on the EM sidelines, and the good news is that they can be overcome.
Home country bias. This behavioral finance concept describes a widespread investor mistake: over investing in one’s own country, as Russ Koesterich has aptly described it. For Americans, this means over allocating to U.S.-based securities. Potential explanations for this bias include people’s tendencies to prefer what’s familiar and to be too optimistic about their home markets.
Just knowing that this bias exists can help investors overcome it. So too can learning more about EM investments. For example when investing in exchange traded funds (ETFs), it’s a good idea to familiarize oneself with the funds’ country and sector breakdowns, largest holdings (which often are global companies) and other key fund information by reading the fund’s website, prospectus or shareholder reports.
In addition, investors can further increase their comfort with EM investments by considering domestic investments that have a significant exposure to EMs, such as through revenues or plant locations. However, it’s important to keep in mind that such investments are no replacement for true exposure to EMs, as companies’ stock returns have historically been mainly correlated with their home markets.
Myopic loss aversion. According to this behavioral finance notion, people feel the pain from losses much more acutely than they feel the joy from similar size gains, and they tend to evaluate returns over a relatively short time period. These tendencies can lead investors to strongly avoid short-term losses, making it especially painful for investors to step into EMs after recent market volatility.
To tackle this bias, investors need to become more comfortable with the downside risks of EM investing. One way to do this is to consider EM investments as part of one’s overall portfolio, rather than just looking at them in isolation. Riskier equities may seem less like isolated gambles when they’re considered in a broader portfolio diversification context, given that they aren’t usually perfectly correlated with other assets.
In addition, it can also help to extend the time horizon over which one evaluates performance so that it matches up with the horizon of investment goals, and to evaluate portfolio performance periodically rather than continuously. While stock markets can be highly volatile over short horizons (which we’re seeing now), time tends to smooth out these fluctuations.
Personal experience biases. Finally, when investors form their preferences, or likes and dislikes, and expectations about future returns and risks, they tend to overemphasize their own past personal experiences at the expense of all available information. This barrier can be especially damaging to the portfolios of today’s younger generations, who over the past 15 years have seen two big stock market crashes and therefore may be especially apprehensive of investing in riskier assets like EMs.
The best way investors can overcome this bias: broaden the set of information that investment decisions are based on. For instance, investors should make sure they’re looking at market performance over long time periods and under different macro and market scenarios. For more on what behavioral finance has to do with – and can teach us about — investing, check out my earlier posts.
Sources: Linked to throughout the post
Nelli Oster, PhD, is a Director and Investment Strategist at BlackRock. You can read more of her posts here.
International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets and in concentrations of single countries.
Diversification and asset allocation may not protect against market risk or loss of principal.
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