Is it wise to invest in emerging market stocks?

Investing in Emerging Market StocksEmerging market stocks can play an important role in a diversified portfolio, in particular one with a long-term time horizon. Growth prospects for emerging markets are much higher than those for developed economies. Think of it this way: you are accelerating from 0 to 60mph in an emerging market vs accelerating from 45 to 60 mph in a developed economy.

That said, there are major risks associated with potentially high returns. As stocks are volatile as compared to bonds, so too are emerging market stocks to the stocks in developed nations.

The U.S. and Europe, for example, have established infrastructures, stable governments and legal systems, and strong economies. Buying a large, multinational corporation based in the U.S. or Europe is relatively safe compared with emerging markets.

Consider British Petroleum (BP), something you might know as the gas station where you fill up your tank. First off, U.S. and European consumers are relatively wealthy, so will purchase gas for their cars despite rising prices. And very importantly, the UK government is not going to nationalize (steal) a private company like BP, leaving the shareholders with nothing. BP is furthermore protected by a well-established legal and market infrastructure with many years of history. The countries where BP does its largest business are generally stable, meaning wars or political unrest won't disrupt its business.

In Russia, an emerging market, this is not the case. Yukos, a successful private oil company, has become international news, as its leader was sent to a penal colony for 8 years for challenging the government's views. Currently, Russia is fighting rumours that it is considering oil nationalization.

If, as an investor in emerging markets, you owned shares in Russian energy companies, this is very, very bad news.

On the other hand, some emerging market stocks have outperformed similar stocks in developed countries by many many times. The Dow Jones Industrial Index is a composite of the largest U.S. corporations, and has returned 4% so far in 2005. A similar Chinese index, the FTSE/Xinhua China 25 Index, has returned 17% this year.

However, as much as I like China's growth prospects, I would prefer to invest in a broader Asia index. China's trading partners, like Japan, will benefit from China's growth. However, if China goes to war with Taiwan, or backs away from its recent business-friendly evolution, Chinese stocks could suffer. Being invested in a broader index will provide a cushion.

Another way to participate in the emerging markets is by a specialized mutual fund. Given the differences in languages, laws and even accoutning methods, it is a difficult arena for individual stock pickers to deal with, whereas the mutual fund firm either has, or can obtain, the required expertise.