Investing In Emerging Markets: How Much Is Enough?

Two words are mesmerizing investors from Wall Street to Rodeo Drive: emerging markets. For intrepid investors, emerging markets such as China and Indonesia are a golden opportunity to make money in the world's fastest-growing regions, while others shun the siren calls of greater returns because they are scared by the higher risks.

Still, even cautious investors can reduce the overall risk of their portfolio by investing in emerging markets. Since investment returns in different countries do not move in tandem, the volatility of a portfolio which includes stocks from other countries can be lower than one composed of just U.S. stocks.

But how much diversification makes sense? Leila Heckman and Holly Sze, two global asset allocators at Smith Barney, Shearson Inc., constructed 11 sample portfolios, ranging from one invested 100% in U.S. stocks to one invested completely in eight major emerging markets. They found that from January, 1985, to November, 1993, a portfolio made up of 70% U.S. stocks and 30% emerging markets was less volatile than an all-U.S. stock portfolio. Moreover, the diversified portfolio had an annual return of 19.3% over this period, significantly higher than the 14.8% rung up by the domestic portfolio.

Heckman and Sze found that the least risky portfolio combined 20% emerging markets with 80% U.S. stocks. Of course, for the strong of heart, the right portfolio was 100% emerging markets, which had the best returns but also the biggest market swings.

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