• Daniel Lee

How To Deal With Extreme Volatility When Investing In Emerging Markets

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In today’s video, I want to talk about the potential volatility, drawdowns and losses that you may experience when investing in emerging and developing markets.



Part 1: Why are things more extreme in the emerging markets

There are three reasons why things are more extreme in emerging and developing markets like Asia as compared to developed markets like the United States.


The first is that, generally, emerging and developing markets tend to experience a higher level of social, political and economic instability which contribute to higher levels of uncertainty.


As such, price swings tend to be more extreme as the fear and greed of the investors are amplified by the higher levels of uncertainty in an emerging market as compared to developed markets.


The second reason is that most emerging markets are susceptible to developments in developed countries. There’s the saying that goes like this, when the developed market sneeze, the emerging markets catch a cold.


This is because most emerging markets are heavily dependent on developed countries for things like financing and demand for exports. As a result, emerging markets are affected by more factors as compared to developed markets thereby making them more sensitive to global developments.


The third reason is the perception that investors have towards emerging markets and developed markets. Generally, most investors would treat the developed markets as a form of safe haven and they would perceive emerging markets to be a riskier form of investment exposure.


As a result, when uncertainty increases, most investors will sell off their emerging markets investment and buy developed markets investments in an attempt of a flight to safety.


This difference in perception in the safety of the investments causes huge levels of disparity in the short-term demand and supply of emerging and developed markets investment.


All in all, the combination of all three factors creates a more extreme behaviour when it comes to things like price volatility, drawdown and losses for the emerging market as compared to the developed markets especially in times of rising uncertainty.



Part 2: Should you be afraid?

Should you be afraid of the more extreme price behaviour when investing in emerging markets?


If you are currently sitting on unrealized losses in your emerging market investments, is there a cause for concern? Should you sell off your investments in an attempt to cut your losses?


My short answer to your question is no. If you have a long-term investment horizon, there is nothing for you to be worried about. Here’s why.


If we were to look at the historical price behaviour of the Emerging Market Index, what you will realize is that while the potential volatility and drawdown losses are high in the short run, there is no cause for concern in the long run as the emerging market had always recovered after major drawdowns and losses.

In fact, since the 1988 inception of the MSCI Emerging Markets Index, there have been Eight major drawdowns in emerging markets where the market suffered more than 25% losses and, In each instance, — Eight out of Eight times—the major drawdown was followed by a significant rally and the prices eventually recovered.


If you were to blindly sell off your investments, you would have materialized and locked in your losses instead of sitting through the recovery and profiting from the eventual economic growth and development of the emerging markets.


What about the Asian markets which I constantly preach about when it comes to long term investing? How did they fair in times of uncertainty?

If we were to look at the historical price behaviour of the Asian Ex Japan Equity Index, the same story can be said for the Asian market as what we had previously seen from the Emerging Market Index.


In fact, over the last 25 years, the Asia market had experienced 7 major drawdowns where the investors saw more than 25% losses in a short period. However, just like the emerging markets, the Asian markets had also recovered in every instance.


From the 1998 Asia financial crisis, 2000 Dot Com Bust, 2008 Global financial crisis, 2013 Taper tantrum, 2018 Trade war with China and most recently 2020 Covid-19 pandemic.


The Asian equity had recovered and prospered after every major drawdown and fundamentally, the region as a whole had developed and progressed significantly since 1998 despite the ups and downs that we’ve experienced over the last 25 years.


Long story short, yes, investing in emerging and developing markets is “riskier” in the short run as investors will experience higher levels of price swings more frequently than we may like to have but in the long run, investing in emerging markets had proved to be a profitable operation 100% of the time as long as our investment horizon is long and we are investing in the right emerging market space.



Part 3: What can you do in times of large drawdown and losses?

In times of extreme price swings and potential paper losses, what can you do to ensure that your investment operations remain profitable in the long run?


The first thing that you need to do in times like this is to calm down and understand that recessions and corrections are part and parcel of investing.


Understand that businesses and investments behave in cycles and every cycle, there are periods of expansion where things will perform well and there are periods of recession where things will perform not so well.

Recognise that this type of cyclical behaviour is normal and that as long as the growth trend remains to be upwards sloping – which is often the case for emerging and developing markets – in the long run, your investments will recover and you will be able to make a profit by capturing the long-term growth of the emerging and developing markets that you invest in.


The second thing that you need to do is to stay invested for the long term and don’t try to time the market. As humans, we are susceptible to investment biases which may cause us to behave impulsively that may make us feel good in the short run but sabotage our performances in the long run.


Trying to time the market in an attempt to limit losses or make a profit in the short-term developments is usually the result of us succumbing to investing biases that often goes against common investment principles.


And with all the studies that were previously conducted on the effectiveness of market timing, we all know that it is a fool’s errand.


times of high uncertainty, stop listening to the media that thrives on making clickbait headlines to capture your attention and content that will exacerbate your tendencies to succumb to the investment biases.


What you should do is to refer back to your investment SOP – standard operating procedures – and fall back on your financial modelling and analysis to decide what the next best move would be in times of rising and high uncertainty.


By sticking to your investment SOP, financial modelling and analysis, you will avoid making a decision that is not consistent with your investment strategy and most importantly, you will not make any decision that would impede your long term investment performances as now you are guided by facts and fundamentals instead of your irrational emotions.



Summary

Long story short, investing in the emerging market does carry higher risks in the form of more extreme price behaviours in the short run.


But as we had seen in both the Emerging market index and the Asian index, as long as your investment horizon is long and the growth trend of your investments is upwards sloping, your investments will recover from the short-term losses and in the long run, you will be able to profit from the fundamental growth of the very emerging markets that you invest in.


Remember, in times of high volatility and drawdown losses, do not panic, calm down, turn off the media, stay invested and revisit your investment SOP, financial models and analysis. Do not succumb to your investment biases and short-term emotional impulses.


 

Daniel is a Licensed Independent Financial Consultant with MAS and a certified Associate Wealth Planner that provides:

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Disclaimer:

This article is meant to be the opinion of the author

This article is for information purposes only

This article should not be seen as financial advice

This advertisement has not been reviewed by the Monetary Authority of Singapore


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