There’s a strong case for having at least a benchmark exposure to emerging market (EM) investments, as my colleague Heidi Richardson recently pointed out.
However, despite EM stocks’ attractive valuations and the numerous other reasons to like select EM equities and bonds, many investors continue to underweight the emerging world in their portfolios. To be sure, investor concerns over rising rates and global growth are partly to blame and have been contributing to EM fund outflows lately.
However, behavioral finance theories can also explain why many investors tend to shun EM investments. In fact, I see three psychological barriers keeping many investors on the EM sidelines, and the good news is that they can be overcome.
Home country bias. This behavioral finance concept describes a widespread investor mistake: over investing in one’s own country, as Russ Koesterich has aptly described it. For Americans, this means over allocating to U.S.-based securities. Potential explanations for this bias include people’s tendencies to prefer what’s familiar and to be too optimistic about their home markets.
Just knowing that this bias exists can help investors overcome it. So too can learning more about EM investments. For example when investing in exchange traded funds (ETFs), it’s a good idea to familiarize oneself with the funds’ country and sector breakdowns, largest holdings (which often are global companies) and other key fund information by reading the fund’s website, prospectus or shareholder reports.
In addition, investors can further increase their comfort with EM investments by considering domestic investments that have a significant exposure to EMs, such as through revenues or plant locations. However, it’s important to keep in mind that such investments are no replacement for true exposure to EMs, as companies’ stock returns have historically been mainly correlated with their home markets.
Myopic loss aversion. According to this behavioral finance notion, people feel the pain from losses much more acutely than they feel the joy from similar size gains, and they tend to evaluate returns over a relatively short time period. These tendencies can lead investors to strongly avoid short-term losses, making it especially painful for investors to step into EMs after recent market volatility.