The Error-Proof Portfolio: Economic Growth Doesn't Equal Portfolio Growth

My Error-Proof Portfolio column is dedicated to helping you avoid common investing mistakes. Well, now it's time to share a mistake of my own. One of my first mutual funds, which I purchased in the 1993, was an emerging-markets fund. Never mind asset allocation, never mind the diversified starter funds such as  Vanguard STAR (VGSTX) or  Dodge & Cox Balanced (DODBX) that I often recommend. Tales from college friends traveling in Asia and Latin America had made me a true believer in the growth of emerging markets.

On its face, the decision to invest in emerging markets wasn't a mistake at all: Although emerging markets stocks have advanced in fits and starts during the past decade and a half, they've dramatically outpaced developed-markets firms. And had I bought and held my emerging-markets fund, I would be gloating now. But I didn't hold. When the Mexican peso crisis roiled Latin American stocks in 1994 I started getting nervous. And when the Thai baht devaluation and Long-Term Capital Management crises hit in 1997 and 1998, respectively, prompting huge losses in emerging-markets stocks in those years, I decided I didn't want a dedicated emerging-markets investment after all.

That tale of investing stupidity illustrates one of the key mistakes investors make when investing internationally. They confuse a great story--the prospect of torrid economic growth in a given market--with the actual investment.

Of course, the two needn't be mutually exclusive--that is, sometimes a great story can also be a great investment. But in my case, I bought the great story about emerging-markets growth without doing two things first. One, I did not adequately consider that emerging-markets' valuations were lofty when I made my initial purchase, and two, I did not have an appropriately long time frame and risk tolerance to hold emerging markets.

A Vanguard study released this past spring illustrates this point well. In short, the firm's analysis shows the economic growth is a very weak predictor of market performance. The paper's authors write, "Our analysis shows that the average cross-country correlation between long-run [gross domestic product] growth and long-run stock returns has been effectively zero. We show that this counterintuitive result holds across the major equity markets over the past 100 years as well as across emerging and developed markets over the past several decades."

That corroborates earlier research by academic researchers Elroy Dimson, Paul Marsh, and Mike Staunton, who, in an exhaustive study of global economic data, also showed that economic growth is weakly, even negatively, correlated with market performance. In fact, the best-performing markets during the time frames studied were those countries marked by flat or even declining economic fortunes. Vanguard's research highlights the 110 years from 1900 to 2009, a period in which the United States emerged as an economic superpower and Great Britain's economic fortunes generally declined. Yet market returns from the U.S. and Great Britain were roughly equal during that stretch.

So if GDP growth isn't a predictor of market performance, what is? Market valuation. Vanguard's research shows that emerging markets have generated robust returns during the past decade not because of economic growth in and of itself. Rather, coming into the 2000s, investors' expectations about economic growth in emerging economies was relatively tepid, and valuations were, as well. That combination--muted expectations plus relatively low valuations--set the stage for very robust market returns.

Bottom Line
Is the takeaway that international investors should run like the wind from Brazil, China, and India and learn to love the U.S., France, and Japan instead? Do they need to conduct a scrupulous analysis of market valuations before sinking any money overseas?

Not necessarily. But it is a healthy reminder to stay diversified geographically rather than focusing exclusively on regions where the growth story is the most exciting, as is the case with emerging markets right now. That's one reason why most of my developing-markets exposure now comes via my 401(k) holding in  American Funds New World (NEWFX), which owns developed-markets companies that stand to benefit from growth in emerging-markets rather than focusing exclusively on direct investments in emerging markets. (My other international funds also have the flexibility to delve into emerging markets, but they're not wedded to them.)

It's also a call to think twice before sinking an outsized share of your portfolio into an investment sector where expectations for future growth prospects are very lofty and valuations have been heading up to match. While few are sounding the alarm bells that emerging markets are extremely overheated right now, the output of  Morningstar's ETF Quickrank hints that they're not a screaming buy, either.  BLDRS Emerging Markets 50 ADR Index , which tracks the largest emerging-markets stocks trading as American depositary receipts, is currently trading right in line with our analysts' estimates of the value of its underlying holdings. By contrast, SPDR DJ Global Titans (DGT), which tracks a basket of global mega-caps, is currently trading at a 10% discount to our analysts' estimate of its holdings' fair value.

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