Portfolio Design: A Modern Approach to Asset Allocation

RISKS OF INVESTING IN EMERGING STOCK MARKETS

Emerging markets are inherently risky. This is seen most simply by comparing the standard deviations of the emerging market indexes with those for the developed markets as in Table 6.2. But there are two features of emerging market risks that need to be explored in more detail. The first concerns the impact of emerging market stocks on portfolio risk. Emerging market stocks tend to be relatively low in correlation with developed country stocks, so their contribution to the overall risk of the portfolio may not be that great. The second feature concerns the volatility of emerging market stocks. The risks of emerging market stocks may be underestimated by conventional measures because they are prone to crises.

Table 6.3 reports correlations between emerging market stocks (MSCI Emerging Markets Composite Index) and the two developed country indexes, the S&P 500 and EAFE indexes. Two sets of correlations are shown, the first for the period beginning in 1989 when the investable indexes start and the second for the last 10 years alone, 2000 to 2009. For the period as a whole, the correlation between emerging market stocks and the S&P 500 is moderately lower than that found between the EAFE index and the S&P 500. A correlation of 0.66 is certainly lower than would be found between two types of U.S. stocks, like small-cap and large-cap stocks or value and growth stocks. So it shouldn’t be surprising that diversification into emerging market ...