All the old warnings about these racy markets are ringing true again. Here's what they mean for your investments. By Elizabeth Leary, Contributing Editor November 4, 2008 You may have noticed a pattern to most of the articles you've read about emerging markets over the past five or so years. First, the typical article tantalizes readers with the off-the-charts returns and wildly optimistic growth prospects of Investment XYZ. Then, tucked somewhere near the end of the story, the article mentions that emerging markets are extremely risky and should account for only a small portion of your portfolio. No disclaimer can restore the 57% average loss investors have taken in their emerging-markets funds over the past year. But it's worthwhile to revisit just why that warning is there, and what it means for your investments. 1. This is what downside volatility feels like. Few seem to care about volatility when stocks are surging. Over the five-year period that ended in 2007, the MSCI Emerging Markets index gained 37% annualized; in 2004, its worst calendar year during that period, it still returned 26%. In 2008, volatility has gone up across the board -- even in ho-hum investments such as municipal bonds. "This year has busted the parameters for what we thought any given category would do in a year," says Morningstar analyst Bill Rocco. Advertisement In fact, relative to, say, the U.S. market, the increase in volatility in emerging-markets stocks has been modest. Over the past 15 years, the MSCI Emerging Markets index has, on average, been 1.6 times as volatile as Standard & Poor's 500-stock index. Over the past year, the Emerging Markets index has been 1.7 times as volatile. "It's not surprising that more aggressive types have fared worse," Rocco says. 2. We're intimately connected. Investors were hoping that the conventional wisdom -- that when the U.S. sneezed, emerging markets would catch a cold -- was no longer operative. The new thinking was that emerging markets had become strong enough to withstand turmoil in the developed world. That might be why emerging-markets stocks began sporting higher price-earnings ratios than stocks in developed markets toward the end of the bull run in 2007. Historically, P/Es of emerging-markets stocks were 35% to 40% lower, to account for their greater risks. But instead of soldiering on without the U.S., emerging markets caught pneumonia. "For the past 20 years, the global economy has been driven by two countries that are linked together -- the U.S. and China," says Jerry Zhang, manager of Evergreen Emerging Markets Growth fund. "One has a huge appetite to consume, and the other has a huge appetite to produce." That growth engine, he says, drove the commodities boom, which enriched resource-rich nations such as Russia and Brazil. So when U.S. consumption overheated, the whole system melted down. Zhang says he still thinks that emerging economies could "decouple" from the developing world over the very long term. Until that happens, don't assume that emerging-markets stocks can escape a global rout unscathed. Advertisement 3. Flighty investors make for fleeting gains. It's impossible to tell how much of the emerging-markets bull run can be attributed to leveraged investors (think hedge funds) and speculators. But it's fair to say that when push came to shove, many investors bolted quickly from emerging markets. "A lot of money coming in to emerging markets has been from overseas," Zhang says. "In a crisis, people bring their money home." Investors who borrowed money to boost their gains have magnified the selloff by having to dump big positions rapidly. "The hedge funds have been going through a huge deleveraging process on a massive scale," says James Donald, co-manager of Lazard Emerging Markets fund. Until emerging markets build up a stronger domestic investor base, they'll continue to be vulnerable to periodic knee-jerk selloffs. 4. Don't have a plan? Better get one. If you have a plan, it will be that much easier to make sensible decisions in the next rout. Decide how much to allocate to emerging markets and write down your plan, building in a time horizon for when you'll start to wind down your exposure. And remember that, as any given part of your portfolio performs better than the pack, you will have to periodically pare back those holdings. That's called rebalancing. Emerging-markets stocks don't have to be a major part of your plan. None of Kiplinger's model portfolios (see Portfolios Using the Kiplinger 25) allocates any money specifically to an emerging-markets fund. Instead, you're more than likely to gain exposure to developing markets through diversified international funds. Based on the funds' most recent shareholder reports, Kiplinger's most aggressive model portfolio has 8% of its assets in developing-markets stocks (we also recommend the T. Rowe Price Emerging Markets Stock fund for investors who want additional exposure). Advertisement 5. Hang in there. If you stick to your plan, you won't have to pull your money out in unfavorable circumstances. And if you don't have to take your money out now, you should probably give it time to recover. "Like domestic funds, it's going to take a long time for these funds to make up their losses," Rocco says. "But I don't see why you should make a paper loss into a real loss."