Rules of the Game: Let Investments Prove Their Mettle

 | Sep 03, 2013 | 10:00 AM EDT  | Comments
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Stock quotes in this article:

EEM

,

VWO

A few days ago, RealMoney's Lindsey Bell started a Columnist Conversation discussion about emerging market stocks. Lindsey asked an excellent and relevant question. I'll repeat it here:

"Money has been flowing out of the emerging markets in anticipation of a Fed pullback for a few weeks now, but the reaction from these markets in the last few days as the Syria conflict surfaced has been extreme. What does this say about the state of the emerging markets? Are they too risky to be involved in as we enter the second half of the year?"

I posted a quick response in Columnist Conversation that same day, but I want to elaborate upon it here.

For those who have been reading my columns in recent months, you realize that I have shifted away from an emphasis on trading and market timing, and toward an emphasis on balanced, globally diversified portfolios structured to provide longer-term income.

The global diversification element is crucial, because you can't predict which asset classes will perform well at any given time. Is it possible to identify particular price, volume and moving-average combinations to time buys and sells? Maybe. Sometimes. It's OK to try market timing if you are using "play money" to speculate on a few stocks. It's a fun game, and gives you some good dinner-party chatter when you can brag about your wins. (There is usually much less party chatter about bad bets, you'll notice.)

But market timing has absolutely nothing to do with your long-term investment philosophy, and is detrimental if you attempt to manage all your holdings via active trading.

Markets are efficient. Contrary to those who believe trading can capture some kind of unknown information, history has shown that securities are priced fairly, and reflect the knowledge and expectations of market participants. Events like the 2010 "flash crash" and the recent Nasdaq shutdown are self-correcting, and don't impact long-term portfolios.

That brings me back to the role of emerging market stocks. First, most people think of large ETFs like the iShares MSCI Emerging Markets fund (EEM) or the Vanguard FTSE Emerging Markets fund (VWO). Both fall into the large-cap style box, using traditional Morningstar categories.

But here's the rub: Small-cap and value stocks historically have better-expected returns than large-caps and growth stocks. That principle should be applied to your emerging market investments.

The key, however, is to allow your investments to prove their mettle over time. Trying to beat some index -- typically the S&P 500 -- for a quarter, week or day is ultimately a meaningless pursuit. First, there is a real danger of putting undue risk on your portfolio. If your gauge is U.S. large-caps, you are still betting the house against an equity portfolio, not leaving room for fixed income to serve as ballast.

Second, contrary to what most U.S. investors have been brainwashed to believe, benchmarking all your equity holdings against the S&P 500 is pretty much irrelevant. Small-caps, international stocks and emerging market stocks, for example, perform differently and should be viewed as discrete portfolio entities, not as vehicles to simply beat 500 domestic large cap stocks.

You want the diversification that emerging market stocks bring, because different asset classes are part of the overall construction. Because historical data show the futility of trying to time entries and exits into particular asset classes, it's higher risk to bail out and then hope you can guess the right moment to jump back in.

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