High Growth, High Return?

A common, but critical, investment misconception was recently highlighted by Jason Zweig in the Wall Street Journal’s Intelligent Investor column. “Under the ‘Emerging’ Curtain” presents a case study of flawed investor behavior by examining the tremendous flow of investment assets to emerging-market mutual funds in 2009.

Zweig’s eye-popping statistic: the $10.6 billion of new investments that have been added to emerging-market mutual funds in 2009 is an astonishing 34 times the new assets added to U.S. stock funds over the same period!

Unfortunately, the explanation for this dramatic activity is all too common. Reason number one is as basic as it gets: performance-chasing – the MSCI Emerging Markets Index has returned nearly 52% year-to-date. However, there’s another reason which, though more subtle, can be just as damaging to investment returns: intuition.

Many investors are allocating larger and larger percentages of their investment portfolio to emerging market stocks in hopes of capitalizing on the projected strong economic growth of countries such as China, India and Brazil. But, while few argue with the rosy long-term outlook for these economies, the intuitive assumption that robust economic growth must surely correlate with strong growth in stock prices simply does not hold. In fact, Zweig cites the research of Elroy Demison of London Business School which shows that stocks in countries with the highest growth rates have earned an average long-term return of only 6% while those in the slowest-growing nations have gained an impressive 12% annually.

How can this be? The answer can be summed up in one word: price. Market prices reflect forward-looking expectations from all public information – when high or sustained growth is widely expected, it’s already reflected in the price of the securities. Only if economic growth exceeds those expectations will above-average returns be realized. Conversely, future growth may still be strong, but if it falls short of the high expectations reflected in current prices, investment returns will likely disappoint.

While we believe emerging markets exposure should remain part of a well-diversified long-term portfolio, the extraordinary 2009 returns driven by heightened expectations and performance-chasing are likely best viewed as rebalancing opportunities – capturing gains emerging markets have delivered and reallocating those profits to investment categories which are more attractively priced.

Truepoint Wealth Counsel is a fee-only Registered Investment Adviser. Registration as an adviser does not connote a specific level of skill or training. More detail, including forms ADV Part 2A & 2B filed with the SEC, can be found at TruepointWealth.com. Neither the information, nor any opinion expressed, is to be construed as personalized investment, tax or legal advice. The accuracy and completeness of information presented from third-party sources cannot be guaranteed.

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