Risks Associated with Investing in Emerging Markets

Investing in emerging markets is exciting. You get to find out about new places and participate in the movement of billions of people out of poverty and into a more prosperous life. And you may be able to reduce your portfolio risk and increase its return at the same time. However, investing in emerging markets has its own issues, and the more you know about them, the fewer surprises you’ll have.

Political and social risk

In any country, investors have to be concerned about changes in the political climate or in the way that society is organized. Even changes that make most people better off may leave a few behind, and sometimes those left behind are investors.

Many emerging markets began their economic improvement because of a major political change. For example, the emerging markets in Eastern Europe were once Communist nations that had to stay in good graces with the Soviet Union. Now, most of these countries are parliamentary democracies with market economies. Such profound changes create risk, and many nations in Eastern Europe have had economic and social upheaval on the way to economic stability. (One of these nations, Poland, has come so far that many observers are surprised to find that it’s still classified as an emerging market.)

Politics being politics, things may turn against investors, too. A country could come into a situation such as war or a natural disaster that destabilizes the economy and pushes commerce down the list of priorities. Investors, especially those outside the country, won’t necessarily be a consideration when the government is tackling what it sees as bigger issues.

Corruption

In many emerging markets, corruption is a fact of business. In some cases, it’s rooted in cultural differences, where people receive tips for services that wouldn’t be rewarded anywhere else. In other cases, corruption is rampant because the people have dealt with ineffective institutions for years and have had to figure out ways to work around them. And in still other cases, the problem is nothing more than basic human nature combined with lax law enforcement.

Corruption affects a business’s ability to present fair financial statements. It adds costs that may not be predictable or manageable. It can throw in surprises and make contracts void in court. It may seem as though a bribe is the quickest way to get business done, but corruption is costly in the long run. Investors usually find that the less corruption a country has, the better its economy. Academic research shows that the less corruption a country has, the less volatile its investment returns are.

Currency risk

In most emerging markets, you use a currency other than your own. That means that your investment returns are affected by changes in the value of both your currency and the emerging-market currency.

Currency risk can work in your favor! In general, a country’s currency becomes stronger (that is, more valuable) as its economy grows.

Liquidity risk

It’s not always easy to buy and sell securities in emerging markets. Some markets are just very small! Jamaica, for example, has a total market capitalization of $4.8 billion. Compare that to one company, Apple Computers, at $254.6 billion! Getting a position in some of these markets may be difficult, and you may have a hard time selling your position when you’re ready to get out. This is known as liquidity risk.

If you limit your emerging-market commitment to the part of your portfolio that’s intended for long-term goals, low liquidity will be less of an issue because you’re less likely to have to sell your positions on short notice.

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