for long term investments, why not go 100% emerging markets?

[wiseheart]

Barron,

You mention commodities as an exception. Could you further explain that?

Thanks.

[cbloom]

The biggest (long term) risk with emerging markets is that they don't ever "emerge", and they just sort of stay 3rd world, and often the most profitable companies in those countries are foreign multinationals.

Also for young people who have reasonable expectation to have a very solid well paying job for many years, you don't really need to worry about risk. When I was younger I would've been happy to put my money in the riskiest investments I could find if I knew they were more +EV.

Like "you need to be thinking of risk-adjusted return and not total return" is standard advice but it just isn't true. It depends on your goals and time frames. There is a curve of risk-EV. An optimal investment is somewhere on that curve, but it's totally up to the individual investor where they want to be on that curve. Investments off the curve are just dumb (lower return at the same risk, or higher risk at the same return).

The problem with putting everything in emerging markets is that you can be sure it's riskier than a broader fund, but you don't know it's more +EV.

[Tupacia]

[ QUOTE ]
The biggest (long term) risk with emerging markets is that they don't ever "emerge", and they just sort of stay 3rd world, and often the most profitable companies in those countries are foreign multinationals.

Also for young people who have reasonable expectation to have a very solid well paying job for many years, you don't really need to worry about risk. When I was younger I would've been happy to put my money in the riskiest investments I could find if I knew they were more +EV.

Like "you need to be thinking of risk-adjusted return and not total return" is standard advice but it just isn't true. It depends on your goals and time frames. There is a curve of risk-EV. An optimal investment is somewhere on that curve, but it's totally up to the individual investor where they want to be on that curve. Investments off the curve are just dumb (lower return at the same risk, or higher risk at the same return).

The problem with putting everything in emerging markets is that you can be sure it's riskier than a broader fund, but you don't know it's more +EV.

[/ QUOTE ]

It's clear from your post that you don't understand the concept of risk-adjusted return. You can aim for a 500% return but you should still be focused on return per unit of risk. A focus on risk-adjusted return is not a prescription to focus on safe or conservative investments, but rather only to account for the element of risk in evaluating investment performance.

[DcifrThs]

[ QUOTE ]
Lebowski,

First, you really can't be sure that emerging markets will outperform. The chance of really bad things like currency devaluations, socialization of industry, civil war, etc etc is all much higher and it might turn out 20 years from now the US market has outperformed emerging markets because emerging markets got hit with a bunch of bad things along the way. But you really can't know.

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right, you can't know...but we are in an era now where developing countries, on the whole, are far less exposed to those huge crises that plagued them for the past 2.5 decades.

they have (again, on average, there are exceptions) sizable current account surpluses (andt hus large foreign exchange reserves) and are not borrowing internationally through the boom (as has been done in the past). instead, they are consuming domestically and in some cases improving infrastructure.

overall, EM equities/debt look more attractive in terms of risk than they have in the past due to the way they are growing now.

either way, thats not here nor there since you still dont' want to put all eggs in one basket.

[ QUOTE ]


Second, if you have a long time horizon then risk is not volatility and anyone who says it is doesn't know how to think for themselves. It's better to have a lumpy 15% then a smooth 12% assuming that you have the stability to ride out the lumpy parts. So if you do assume that emerging markets will have a higher absolute performance then yes you would want to put your money there.

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no, you wouldn't.

ironically, this statement shows that you are the victim of what you've accused those who believe otherwise. i think you are toting a line that you've read or just thought about without digging deeper and thinking "for yorueslf."

let's look at it this way, if you have 15% expected returns with 45% annual volatility vs. a 12% expected return with 15% annual volatility, which would you rather invest in for 30 years? and why?

on the surface, assuming you have a very large bankroll, you'd earn more with 15% over 30 years than with 12%, but your risk adjusted return is only .3 vs. .8.

what this means is that you could leverage the 12% investment THREE TIMES to an annual volatility of 45% (to match the "lumpy" 15% return) and be generating, on average save leverage costs and transaction costs, 36% return vs. a measly 15%.

even if it costs 6%/year (really large and probably more than it would in reality) to get that 45% vol, you'd still be generating a .66 risk adjusted return vs. a .3 risk adjusted return and be getting two times as much return for the same level of risk.

that is why you would never choose a "lumpy" return over a "flat" return if you have access to leverage.

another way to look at it is to imagine a monte carlo simulation where you run the "lumpy" investment 100 times for 20 years vs. the "flat" investment 100 times. ni the lumpy scenario, there are instances (maybe 5% or something) where the last year is a -10% or -20% year that wipes out a large amount of the previous 20 years of gains. the flat scenario would almost never have that huge loss, but wouldn't have those huge gains also.

to be clear, that last example was just another way tot hink about it and in theory isn't applicable to this discussion. you are right that if you have $1bil, no access to leverage, and you want to invest $500mil to generate the largest returns, you'd want to invest in absolute 15% vs. 12% assuming you could expectt hat over time.

the problem is that the riskier "lumpy" investment is suboptimal if you can access (Even a small amount of) leverage.

in my initial example, i chose extreme values to prove the point, but you may only need 1.2:1 levarege vs. 3:1 leverage to surpass the "lumpy" investment.

Barron

[DcifrThs]

[ QUOTE ]
Barron,

You mention commodities as an exception. Could you further explain that?

Thanks.

[/ QUOTE ]

i've spoken at length about this many times on this forum, but shortly:

excess returns come from a tranfering of risk premia. commodities that are backwardated have proven over time to generate a risk premium from hedgers (producers who sell their product in the future) to speculators/investors (those who take long positions ...this could also be "hedgers" of input costs, but nowhere near as often).

historically, the sharpe ratio of commodities has been .15 or so, well below the .2-.3 level of other 'asset classes.'

as more people invest/speculate in the rise of commodity prices, the lower that risk premium becomes.

overall, i'd expect a risk premium from commodity investment to be positive, and relatively small (maybe .05-.1 risk adjusted return).

that is probably about the consensus for those that think about this stuff (and a consultancy "Rocaton" that generates these estimates for a living)

Barron

[stinkypete]

[ QUOTE ]
another way to look at it is to imagine a monte carlo simulation where you run the "lumpy" investment 100 times for 20 years vs. the "flat" investment 100 times. ni the lumpy scenario, there are instances (maybe 5% or something) where the last year is a -10% or -20% year that wipes out a large amount of the previous 20 years of gains. the flat scenario would almost never have that huge loss, but wouldn't have those huge gains also.

[/ QUOTE ]

it baffles me every time i hear people who are actually educated in these matters say something like this.

who cares if you drop 20% in the last year? you could also drop 20% in the first year, wiping out 20% of your gains for the next 19 years.

guess what? multiplication is commutative!

consider this example:

what is 0.8 * 1.15^19?
how about 1.15^19 * 0.8?

and if you suddenly become risk averse in your last year, you can always invest in something else.

also, i don't see why you're throwing around jargon like "monte carlo simulation", which half the readers here won't understand, when you could easily get your point across using simple explanations.

[stinkypete]

also, when you're dealing with 3x leverage and 45% volatility like in your example, comparing that volatility number with a portfolio with no leverage is apples to oranges.

your risk of being wiped out entirely at 3x leverage and 45% volatility is HUGE (this is where those monte carlo sims you love talking about might actually come in handy). with no leverage, it's essentially zero.

[Gigi]

[ QUOTE ]

who cares if you drop 20% in the last year? you could also drop 20% in the first year, wiping out 20% of your gains for the next 19 years.

guess what? multiplication is commutative!

consider this example:

what is 0.8 * 1.15^19?
how about 1.15^19 * 0.8?

and if you suddenly become risk averse in your last year, you can always invest in something else.


[/ QUOTE ]

The point being made here is you don't want something this volatile when you're about to retire (ignore the past it already happened). This is why there is a tendency to gradually allocate more of your portfolio to fixed income securities as you get closer to retirement. Given one last year to invest, it is wise to choose an investment with a lower unit of risk. In this case choose the 12% expected return with 15% annual volatility instead of the 15% expected returns with 45% annual volatility.

[ QUOTE ]

also, i don't see why you're throwing around jargon like "monte carlo simulation", which half the readers here won't understand, when you could easily get your point across using simple explanations.


[/ QUOTE ]

Montle carlo simulation are easy to understand and they are taught in intro business classes, or if you used pokerstove. They apply perfectly to this situation.

A portfolio with 3% expected return 9% std dev will not always be in the money after 20 years! However, a 2.4% expected return 3% Std Dev portfolio almost always will be, which is kind of important if you want $$$ when you retire.
As seen here: http://www.moneychimp.com/articles/risk/longterm.htm
(I changed all the units by a factor of 1/5th because the the std dev input is limited to a maximum of 20% on this site.)

[stinkypete]

[ QUOTE ]

Montle carlo simulation are easy to understand and they are taught in intro business classes, or if you used pokerstove. They apply perfectly to this situation.

[/ QUOTE ]

sure it applies, but for the point he was making theres easier ways to get the point across. using the monte carlo option on pokerstove doesn't equal understanding monte carlo simulation. but whatever, thats not really the point of this thread.

[DcifrThs]

[ QUOTE ]
also, when you're dealing with 3x leverage and 45% volatility like in your example, comparing that volatility number with a portfolio with no leverage is apples to oranges.

your risk of being wiped out entirely at 3x leverage and 45% volatility is HUGE (this is where those monte carlo sims you love talking about might actually come in handy). with no leverage, it's essentially zero.

[/ QUOTE ]

dude, i compared 2 portfolios and picked extreme #s. in any case, your statement is absolutely incorrect.

if you have a portfolio that returns 15% at 45% volatility with no leverage, you are equally likely to be "wiped out" if the exact same investor has a 5% return portfolio with 15% volatility leveraged 3:1. (i picked 5% return here to make the resulting portfolio identical save transaction/leverage costs)

it isn't apples to oranges. it is a perfectly fine comparison. and didn't you get the point of my post? i'm trying to instruct on efficient portfolio construction. don't get pissy because i use a word "monte carlo" since most here would easily get that.

jeez

Barron