As a beginner investor, you likely have quite a few questions. As you research the best way to go about participating in the stock market, you’ve no doubt come across the term “emerging markets” a time or two.
Others seem to be making a killing investing in emerging markets, so why can’t you?
Of course you can but, as you’ll learn, investing in emerging markets can be risky business. Here’s what you need to know before you dive in.
What Are Emerging Markets?
There are two different types of emerging markets. In most cases, when investors and experts talk about “emerging markets,” they’re actually talking about emerging economies. These are economies around the world that show some of the signs seen in developed markets, but not all of them. The general consensus is that emerging economies are growing and will eventually become developed markets.
The other type of emerging market is centered around emerging trends and industries. These are trends that surround new technologies or other products that there was no market for in the past, but that are gaining traction among consumers.
As mentioned above, emerging economies are international economies that are growing into developed markets, but are not quite there yet. Essentially, these economies are going through a transition from being smaller and playing a small role — if any — in the global economy to becoming a larger, more robust economy and taking part in global trade.
These emerging markets tend to experience economic growth at a much faster rate than developed countries because they are catching up to markets that have already developed. Some of the most popular emerging market economies among investors include China, India, Brazil, Argentina, Hong Kong, Turkey, and Russia.
Emerging trends, on the other hand, are new markets that are blossoming surrounding newly available products or services. For example, one of the largest trend-based emerging markets at the moment is the cannabis market.
Due to the recent legalization of adult-use cannabis in Canada, along with decriminalization or legalization of cannabis in most states in the United States, the cannabis market is now an emerging industry. After all, now that it’s possible to legally grow and distribute cannabis in various regions, businesses are popping up left and right to fill the demand.
Another massive, and growing, emerging market is the coronavirus market. With the virus leading to a pandemic, several companies are working to develop personal protective equipment, vaccines, and treatments to protect consumers around the world against the ailment.
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Benefits of Investing in Emerging Markets
Ultimately, there are several reasons investors get involved in emerging market stocks. Some of the most significant benefits to investing in emerging markets include:
- Potential for Significant Gains. These markets are often in their infancy and tend to grow quickly. As the emerging economy or emerging trend grows, valuations within the market follow, especially among market leaders. Because emerging markets tend to grow at a faster rate than developed markets, emerging market stocks also generally experience a higher growth rate than those in developed markets.
- Emerging Markets Are Exciting. Whether you’re talking about a developing economy that’s experiencing strong gross domestic product (GDP) growth and beginning to play a major role in the global economy or a young industry that’s blooming around newly available technologies and other products, following the growth in emerging markets is often an exciting endeavor. This excitement makes the market research more enjoyable, making it more likely that the investor will make more educated decisions.
- Emerging Market Stocks Enjoy High Levels of Liquidity. Emerging markets are a hot topic among the investing community. As such, there’s strong demand for quality stocks within these markets, leading to high levels of liquidity and making it easier to sell shares if you decide that your investments in these markets are no longer aligned with your goals.
Risks Associated With Investing in Emerging Markets
Although there’s plenty to look forward to when investing in emerging markets, there are also plenty of risks to consider before investing your first dime. Some of the most significant risks to consider include:
- High Levels of Volatility. Emerging markets aren’t quite developed yet. As such, investments in these markets are highly speculative and the bears and bulls will struggle to keep stocks going in either direction, leading to high levels of volatility. When investing in markets with high levels of volatility, there’s just as much risk of significant losses as there is potential for significant gains.
- There’s No Past Performance. A successful investor will look into the past performance of companies they’re interested in prior to making their investment. In emerging markets, there’s often not much in the way of historic performance to compare to. Investing in relatively new companies in emerging economies or new industries comes with increased risk because these businesses usually don’t have a proven track record of leadership or producing consistent profits.
- Penny Stocks are Dangerous. As a consequence of working in new and growing markets, emerging market stocks are generally in the penny stock category with market capitalizations of less than $500 million. Penny stocks are dangerous in that the wrong move with these stocks can lead to fast-paced, significant losses.
How to Invest in Emerging Markets
Investing in emerging markets isn’t for the faint of heart. If you are a risk-averse investor, you’ll be better served investing in other, lower-risk categories. However, if you like to live on the wild side and are willing to accept the risks associated with emerging market investments in order to cash in on potential market-beating profits, keep the tips below in mind.
1. Invest in Clear Leaders
In emerging markets, no company has a history of being the leader. However, that doesn’t mean clear leaders aren’t beginning to emerge. For example, early in the COVID-19 pandemic, Moderna and Pfizer announced they would be working on COVID-19 vaccines. Throughout 2020, these companies maintained their leadership, moving forward with clinical trials faster than their competitors, signing agreements for the commercialization of their vaccines, and setting the stage for leadership ahead.
In late 2020, both Pfizer and Moderna announced the launch of their COVID-19 vaccines. As the only two companies with approved vaccines on the market, these became clear leaders in the emerging COVID-19 market.
In any emerging market, there are just about always a handful of companies that are far ahead of their competition. These are the companies you’ll want to consider investing in, as they will have the strongest probability of success.
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2. Invest in Companies With Institutional Backing
Institutional investors are considered “smart money” investors because they live, eat, and breathe the stock market. These investors are charged with investing money on behalf of their customers, often managing portfolios with values in the billions of dollars.
If a company in an emerging market has real potential to become a leader as the market develops, there’s a strong chance institutional investors will be all over it. After all, these investors want in on the growth as much as you do — they just have more time for research and a professional standing in the stock market.
You can check for institutional holdings at Nasdaq.com looking up the stock symbol using the search bar and clicking on the Institutional Holdings link on that stock’s page. If there are no institutional holdings, it’s likely best to stay away from the investment for now.
3. Invest in Companies With Solid Intellectual Property
Warren Buffett once said, “The most important thing [is] trying to find a business with a wide and long-lasting moat around it … protecting a terrific economic castle.”
Buffett uses the term moat to mean a metaphorical, economic moat in this case. Essentially, you’re looking for a company that has built a solid competitive advantage — a strong brand or a list of patents, trademarks, and copyrights that can be used to protect the company in the event that a competitor attempts to mimic their products.
In emerging markets, economic moats are crucial. As the market grows, competition will grow as well. Companies that got in on the market early, taking control with cutting-edge products or services, must protect their competitive advantage to realize long-term success.
4. Be Sure to Diversify
Because emerging market stocks are highly speculative bets, it’s important to protect yourself should you choose to invest in them. To do so, it’s important to practice diversification.
Diversification is the process of spreading your investments out over several different investment options. As a result of doing so, if one of your investments realizes significant losses, your entire portfolio isn’t at risk.
One of the best ways to go about diversification is to follow the 5% rule. Under this rule, you would never invest more than 5% of your total portfolio value in a single stock or more than 5% of your total portfolio value in a group of high-risk stocks.
For example, if you have an investment portfolio with $10,000, you shouldn’t invest any more than $500 in any single stock or across a group of high-risk stocks.
Because emerging markets tend to be riskier plays, you might limit yourself to investing 5% of your portfolio in all your emerging market investments combined.
One way around this is to invest in less risky, established companies with ties to emerging markets or trends, but whose entire business isn’t dependent on them. For example, instead of investing in a more speculative Chinese company, you might invest in a large, multinational U.S. company with a fast-growing segment of its business in China.
5. Avoid High Valuations
The point of investing in emerging markets is to take advantage of the outsize growth in the space. However, if a stock already has a valuation above the norm for the market in which it lives, your chances of experiencing significant gains are diminished.
Successful investors, whether in emerging or developed markets, look for companies that are undervalued compared to their peers. To do so, these investors use a wide range of valuation metrics, typically including the price-to-earnings ratio, price-to-sales ratio, and price-to-book-value ratio, at the very least.
Before investing in any emerging market stock, look into the current market valuation of the stock. If valuation metrics show that the stock is overvalued compared to its peers, it’s best to pass on the investment and either wait for the price to pull back or look for other opportunities that come with more sensible valuations.
6. Consider Emerging Market ETFs, Mutual Funds, and Index Funds
Investing in emerging markets is a fun process for the right investor, but it’s also cumbersome and can be risky. If you don’t have the time to do the research or simply don’t have the experience as an investor to feel comfortable investing in the space, you can gain access to emerging markets through targeted exchange-traded funds (ETFs), mutual funds, and index funds.
These funds are bucket investments that use their assets to invest in a wide range of emerging market stocks. Some of the most popular emerging markets funds include:
- iShares MSCI Emerging Markets ETF (EEM). The iShares MSCI Emerging Markets ETF is an exchange traded fund designed to track the MSCI Emerging Markets Index. This index tracks emerging market stocks ranging from small-cap to large-cap. So, investing in the ETF provides overall exposure to emerging markets.
- Vanguard Emerging Markets Stock Index Fund (VEMAX). The Vanguard Emerging Markets Stock Index Fund is an index fund focused on exposure to emerging market countries, with vast holdings in the semiconductor space.
- VanEck Emerging Markets Fund (EMRZX). The VanEck Emerging Markets fund is also heavily focused on emerging market countries. In particular, the fund has large holdings in international e-commerce companies, data centers, telemedicine companies, e-payments, and electronics companies.
Emerging markets are exciting, and investing in them can prove to be incredibly lucrative. However, making the wrong moves in the space will prove to be painful. As a result, it’s best for beginner investors to get their feet wet with developed markets until they believe they have a relatively strong understanding of the stock market and what makes it tick.
If you feel you’re ready to start investing in emerging markets and taking your share of the strong gains seen in the space, keep in mind that the key to successful investing is research. Never blindly make an investment in an emerging market stock simply because it’s seeing strong growth or because of online buzz. Get an understanding of where that growth is coming from and whether it’s a sustainable investment.