Chapter Seven

The Reality of Risk

And Why Not to Fear It

Modern portfolio theory gives a technical definition of “risk” that is very different from what we would normally think of risk. It defines risk as volatility calculated by the variance (as measured by the correlation coefficient) of a portfolio’s historical returns. Therefore, a portfolio that is yielding excellent returns to an investor may have a “high-risk” profile if those returns have been volatile over the years.

Investing in emerging markets is not, they say, for the faint of heart. But then again, as the U.S. subprime crisis showed us, neither is investing in developed markets.

If we’ve learned anything in the past few years, it’s that emerging markets are not as risky, in the traditional sense, as they were 10 or 20 years ago. If anything, some of the more mature emerging markets could be said to be even safer than the so-called developed markets, since the growth prospects are so much better. This clearly seems to be the case when you compare emerging market giants such as China and Brazil with developed economies such as Italy and Spain. However, risk in the sense of volatility still exists and because of high velocity trading, derivatives, and more efficient global trading networks, that volatility has actually increased in not only emerging markets but also in developed markets.

One solution to minimize portfolio volatility and thereby the risk (i.e., making your returns as close to constant as possible) is to invest in countries with markets that have a low relation or correlation with each other. By investing in stocks of countries that have low correlation coefficients with each other, the volatility of your global portfolio is reduced, and, by extension, the risk to your investment.

Of course, the volatility definition of risk and the relatively simple solution for reducing volatility through diversification does not explain the entire picture of risk in emerging markets investments.

The Big Picture

Over the years, I’ve become all too familiar with the significant risks that investors face in emerging markets. In no particular order, they include:

• Political risk: The possibility that revolutions or political turmoil in a country could significantly impact the value of an investment.
• Currency risk: The impact on an investment of fluctuations in a national currency.
• Company risk: Any risk arising from exposure to a particular company, such as the lack of information, a change in the company’s management or ownership, a change in the health of a business, depression in a particular industrial sector, or a sudden price panic.
• Broker risk: Risk of unscrupulous or dishonest brokers who use customer orders to “front run,” that is, to buy or sell ahead of their clients to take advantage of the market price differences.
• Settlement risk: Problems experienced in trying to settle transactions, and in obtaining, registering, and paying for securities.
• Custodial risk: Exposure to local safekeeping agents (popularly known as custodians) who may not provide adequate security for clients’ shares.
• Operational risk: Risk arising from inadequate auditing and bookkeeping standards.
• Market risk: Exposure to extreme fluctuations in market values and the lack of liquidity.

I’ve disclosed all the major risks I can think of. So why, you might well ask after reviewing that list, should anyone bother with these messy, risky, strange situations? Because those risks exist in all markets, emerging and developed, and diversification internationally reduces the impact of such risks.

If you want to hit the financial home runs of the future, you’ll need to pay attention to what goes on not only in your home country but everywhere in the world. In 2011, emerging market companies accounted for over 30% of the world’s market capitalization, according to the World Federation of Exchanges. Thus, even the most prudent investors in search of diversification and asset allocation should consider investing one-third of their total portfolios in emerging markets, whether that investment be made in individual stocks or in an ever-growing list of emerging markets mutual funds.

As I have pointed out, historical stock market performances in emerging markets also back up the view that emerging markets have outperformed developed markets.

Before deciding to invest in any region, country, or company, all possible risks must be considered and one of the first to examine is the market liquidity, the investor’s ability to buy and sell a stock quickly and efficiently. If a market or stock turnover is low, of course the ability to buy or sell is hindered, which is a disadvantage. However, in illiquid markets the difference between the buy and sell prices or the “spread” can be wide, thus opening up an opportunity to purchase at bargain prices. Therefore, investing in a low-liquidity, low-activity market can generate phenomenal returns because the purchase of just a few stocks by a few investors can drive the prices of those shares up dramatically. Of course, following the same pattern, a major sell-off in an illiquid market can cause prices to drop catastrophically.

Journalist Christopher Fildes once noted: “An emerging market is a market from which you cannot emerge in an emergency!” This is true of illiquid markets, but such markets should not be ignored since they could contain some excellent investments.

If there is anything we’ve learned in the past few years, it is that developed markets can be as volatile as emerging ones. During crisis times, it isn’t uncommon to see a 5% swing in some markets in one day. But don’t fly off to the United States for a safer ride: The stock market there also had its fair share of ups and downs, as was evident during the subprime crisis.

How to avoid being sideswiped by these risks?

Hedging Your Bets

Let’s take another look at that map of the world. If you could overlay a transparent sheet with a graph of market lows and highs over time, you would see that with few exceptions, regional boundaries still very much define emerging markets.

In an age when jet travel and electronic commerce would seem to dominate an increasingly global economy, it’s surprising how strong local and regional boundaries are. Regional economies in the less industrialized, less wired parts of the world are obviously knit together by increasingly advanced communications and transportation links. Therefore, changes in one country can impact an entire region.

For better or for worse, when the Mexico Peso crisis hit in 1994, the entire Latin American region suffered from what global investors quickly dubbed the tequila effect. In the same vein, when international currency traders began to seize on weaknesses in the Association of South East Asian Nations (ASEAN) countries—Indonesia, Malaysia, and Thailand primarily—the ripple effect that coursed through the region was called the Asian currency contagion and the Asian financial flu.

In both regions, certain countries (Hong Kong in Asia, Chile in Latin America) stood to some degree above the fray. But all global investors contemplating where to put whatever funds are at their disposal should first ponder the impact of regional changes and input that information in their research calculations. It is important to remember, however, that these regional movements where all countries in one region move together in one direction are temporary, and after a crisis, each country—each company—adopts its own behavior and stock price changes, which can be highly uncorrelated.

So, what should you do when there is a market crisis and it seems that all the stock markets are on fire?

Sit Tight, Don’t Worry, Be Happy

If you have done your homework and selected a well managed mutual fund or put together a well diversified portfolio of undervalued stocks, then the best thing to do is: “Sit tight, don’t worry, be happy.” As long as the fundamentals are on the money, the companies will bounce back again, usually stronger than ever before. Please remember: Your best protection is diversification and patience is more than its own (just) reward.

If someone tells me he wants to become rich in less than one year in emerging markets, I tell him to take his money elsewhere. The swings in stock markets make market timing difficult and, if your timing is terrible, it can be very costly. The only way to consistently stay ahead of the game is to adopt a long-term view and, if appropriate, with a strong contrarian spin.

When we look at the balance sheet of a company, we might be willing to pay a high P/E ratio if we think that the company will achieve the high growth needed to obtain what might become a low P/E ratio in five years’ time.

The single most important lesson I’ve learned is that long-term planning pays. The reason for this is astoundingly simple. All markets are fundamentally cyclical. Like people—because they’re composed of the aggregate decisions people make—they’re given to extended bouts of irrational fear and panic and equally irrational exuberance.

Like adolescents, we can get a little bit carried away at times. But—and I can’t repeat this enough—it is by riding these wild mood swings like a surfer taking a wave that the investor can make money. An entirely rational market, after all, is a market that would barely budge at all.

The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell. That seems counterintuitive, right? Well, it is, and therefore it requires a positively stoic ability to let your mind rule over your passions. This brings us unerringly to: If you can see the light at the end of the tunnel, it’s probably too late to buy (or sell).