Ten years into my hardcore investing obsession, I’m still surprised how predictable investors can be.

Take the cycle of fear and greed, for example, and put emerging markets in for spin.

A few years ago you’d get shouted down if you suggested that unloved US and UK equities might be as good a home for your money as emerging markets.

Yet now the average investor doesn’t want to touch emerging markets with a barge pole. [Note to editor: Please insert witty comment about the indigenous boat people of an exotic island nation here.]

There are doubtless multiple reasons why emerging markets have done poorly for the past two or three years. Pundits point to inconsistent economic growth, stifled reforms, political risk, lower commodity prices, and the end of easy money.

To my eyes, though, optimism and pessimism has played its usual starring role – expressed as ever through the valuation put on traded assets like shares.

Emerging markets can go down as well as up

Immediately after the financial crisis, the West was in the doghouse while emerging markets powered ahead. Our shares were cheap on various metrics, theirs were arguably expensive.

Myopic investors made giddy by recency bias assumed this state of affairs would continue forever.

They also ignored warnings that economic growth was not a predictor of stock market returns – basically because anyone can see when a particular country is booming by reading the newspapers and watching the news.

So by the time the average investor – whether professional Gordon Gecko type or enthusiastic oik like us – arrives at a promising scene, the party is in full swing.

If you arrive late, you pay a high price to be part of the in-crowd in terms of the P/E multiples and price-to-book ratios you pay for your shares. That leaves little wiggle room for future disappointments – and sometimes mediocre returns even if things go as planned.

Beaten by the ‘broken’ USA

Since then the mood has soured on emerging markets. Yet all the problems they are said to face today existed when everyone loved them, too – at least on a longer-term perspective – as well as the opportunities.

To me, that makes emerging markets a more attractive place for my money, rather than less so.

If you’re a smart passive investor, you probably already have an allocation to emerging markets. Take this article as simply saying that when you come to rebalance your equity holdings and see that your emerging market index fund is down, hold tight and top up.

Smile inwardly! What goes around comes around. That’s exactly why you’re rebalancing, in fact.

As for us nefarious active investors, the pessimism could make for a fertile hunting ground, especially after double-digit gains in the developed world this year make some of them, notably the US, look more fully valued.

See how the soaraway S&P 500 has trounced emerging markets in 2013:

The S&P 500 has beaten the iShares emerging markets ETF by more than 30% in the year to-date.

Will that stellar level of outperformance continue?

Maybe.

Will it be replayed every year for the rest of the decade?

I’ll go out on a limb and say: Not on your nelly.

We’re all in it together

The extreme case made for loading up to the eyeballs in emerging market shares never made much sense to me, even when they were doing well.

Yes, the citizens of emerging nations are mostly younger than us, and they have faster growing economies. But we were (and are) the wealthy ones, and we have plenty to sell to them, too.

The UK FTSE 100, for example, generates more than 70% of its revenues from overseas. UK consumer goods giants like Unilever (Dove, Bovril, Marmite) and Diageo (Johnnie Walker, Baileys, Guiness) get a huge proportion of their sales directly from emerging markets.

For this reason, even if the UK and US economies were doomed to decades of stagnation or worse – which I doubted then and now – it might be different for our listed companies. Not for nothing do critics of Western capitalism paint them as rapacious locusts scouring the globe for profit.

Besides, I believe the truth is a less sensational halfway house.

Western economies will grow, probably a little more slowly than in the past, and our companies will likely keep a (shrinking) technical edge over most emerging rivals. But the latter will have strong domestic demand to easily tap into.

Emerging markets as a whole will be volatile, and some will utterly disappoint, whether for economic reasons or because they’re taken out in a military coup. Or some lesser evil.

By diversifying and dripping in money over time, you’ll be able to dilute the duds and profit from those markets that – well – emerge!

Emerging market investment trusts

For my part, for 6-12 months I’ve been increasing what was a too-small allocation to emerging markets. Mainly by fiddling about with my index fund allocations but also by buying shares in relevant investment trusts.

So far it’s not been wildly successful, but this is long-term money that I add to piecemeal.

In addition, I own a couple of family-run global investment trusts that have floundered in part due to their emerging market exposure, particularly RIT Capital Partners and Hansa Trust. (The latter is mainly an idiosyncratic bet on Brazil and other emerging markets, though you might not realise that at first).

I have also put more money into companies hurt by their association with emerging markets, such as Unilever when it fell below £23.50.

When I scan some of the emerging market investment trusts, I do wonder if I should be bolder. That’s because fear and greed is doubly captured in the discounts they can trade at to their assets.

Here’s a few I’m mulling over:

	Ticker	Discount/ premium	Yield	YTD1
Aberdeen Asian Income	AAIF	+1.6%	4.0%	-12%
BlackRock Latin American	BRLA	-10%	5.4%	-19%
JP Morgan India	JII	-15.5%	n/a	-10%
Hansa Trust	HAN	-26.7%	2.0%	16%
Templeton Emerging Markets	TEM	-9%	1.2%	-9%

Sources: AIC Stats for trust data and Google Finance for year to date returns.

Please note that I’m not recommending the trusts above as good buys. I don’t give advice, and you will need to do a lot of research yourself.

These are just a few of the trusts that I’ve been considering – and there are plenty of others to look through. In some cases there are definitely reasons to be cautious.

Finally I’ve even boldly gone beyond the pale, to Frontier Markets. Only a smidgeon invested in that, but it’s doing okay so far. It’s one for the very long-term.

Not every emerging markets investment trust looks cheap. JP Morgan Emerging Market Income (Ticker: JEMI) is on a small premium, as is Aberdeen Asian in the table above.

I suspect in today’s yield-hungry world, a 4% dividend yield trumps even fear!

For all the bulls in China

I am not claiming to have called the bottom for emerging markets, or anything like that2. You could imagine them falling much further from grace, especially if investors weren’t being pacified by strong returns elsewhere.

But I do think they look shunned and therefore worth an extra poke.

You might be surprised how quickly sentiment can change. Fidelity China Special Situations (Ticker: FCSS) is a case in point.

• In summer 2013, FCSS reached a low of 81p and the discount surpassed 11%.

• Now they cost 105p to buy. That’s a 30% rise in just five months.

I’m not saying (of course!) that it’s easy or sensible to look for quick returns like that. I’m suggesting it’s a better time to buy and lock away this asset class for the long-term than it was just 2-3 years ago.

Still, the sudden reversal of opinion about China is an excellent example of just how fast people can change their minds about a particular emerging market – and how rapidly it can be reflected in share prices.

1. Year to date. [↩]
2. Especially as I’d be late on current evidence – they seemed to touch base a few months ago. [↩]

Good reads from around the Web.

Still to buy all your Christmas presents? You’ll get no sympathy from me if you intend to shop on foot like some Luddite from the 1980s.

Why not go the whole hog and hit the High Street on a horse?

Me, I’ve done all my Christmas shopping online via Amazon for years now, sending the bulk of it direct to my mum’s house – the scene of the annual family bust-up reunion. It’s become even easier since I joined Amazon Prime. No crowds, no packing, no delivery fees, and no worries it won’t make it on time.

So in the spirit of giving, I’ll share a few Amazon-able gift ideas with you.

Fear not! I won’t try to cherry pick the best BBC box sets or handmade soap.

Instead we’ll stick to what we know, with money and investing book ideas plundered from the many I’ve read and featured here in 2013.

Best for new passive investors

The third addition of Smarter Investing is no more exciting than versions one and two, but my co-blogger The Accumulator swears he’d never have got started in index funds without Tim Hale’s definitive and sober advice. The Bible for UK passive investors.

Best for those who should know better

Investing Demystified by Lars Kroijer is only a little less sleepy than Tim Hale’s tome, but the fact it’s a passive investing treatise written by an ex-hedge fund manager does add some extra frisson. An impressive turnaround.

Best for old-school share investors

John Lee is one of the greats of UK private investing, with the noble Lord having become famous through his FT columns – and his revelation that he was an ISA millionaire by the early 2000s through his investing results. Now we can learn how he did it in his eagerly-awaited How to Make a Million Slowly. I’m glad to report there’s even a Monevator plug on the back!

Best for value investors

I wish I’d bought the attractive hardback version of The Value Investors instead of the Kindle edition – it’s much more in keeping with this old-school method to riches. Good to dip into for a quick inspiring story about some quirky maladjusted male made good. The Asian case studies were all new names to me.

Best for investing wisdom

The Most Important Thing: Illuminated is the new version of Howard Marks’ super distillation of years of investing insights. A must-read for active investors, but in stressing just how hard it is to beat the market – and to run away from the herd –  it could also make a good read for the passive investor in your life.

Think of the children!

There’s a dearth of new books out there for newcomers to investing – a shame given that the state pension age has just been raised to 143 (or thereabouts) and half the country is in hock.

This means it is hard for me to recommend new books for disinterested nieces or nephews.

I still meet people whose life was changed by reading Rich Dad Poor Dad, and even though it’s dated, US-based, and the author is a controversial salesmen, I bet it would still work its magic. Just make sure you steer them clear of his gazillion pound follow-up courses.

[continue reading…]

Back in lesson 3, we saw that different assets can perform differently at different times. But what are these assets? And why should they go their own way?

An asset is something you can own, buy, and sell. It’s the opposite of a liability.

• A house that you own is an asset.

• Your mortgage is a liability.

One man’s asset can be another man’s liability.

Your mortgage is a valuable asset for your bank. You’re contractually obliged to pay it back, plus interest.

The main asset classes

Just as the natural world is divided into broad classes like mammals, fish, and fungi – and mammals then divided into cats, monkeys, and many more – the world of assets divides into big groups, with subdivisions.

In investing, these big groups are called asset classes.

The main ones are:

• Cash

• Bonds
  • Government bonds (UK Gilts or US Treasuries)
  • Corporate bonds

• Shares – Also know as equities

• Property
  • Commercial property
  • Residential property (your house or someone else’s)

• Commodities – Especially gold, but also stuff like forests, cows, and oil

• Alternative assets
  • Wine
  • Paintings
  • Stamps

Different asset classes perform differently from each other for two main reasons:

• Economic conditions – Inflation, interest rates, and economic growth affect different asset classes differently, and at different times.

• Emotion – Investors (asset buyers) are by turns fearful and greedy.

Asset classes in (un) reality

Let’s consider a fictitious company: Brixton Unlimited Nappy Services (Stock market symbol: BUNS).

BUNS was founded in 2000 to sell nappies to mums across London.

To raise the money to get started, BUNS floated on the stock market by issuing 100,000 shares at £10 each, raising £1,000,000. These shares can now be freely traded between investors, so the price changes. Each share is a part ownership in BUNS, entitling the owners to a certain share of the company’s fortunes.

Note that only the initially floatation actually invested money into the company.

If you buy ten shares in BUNS from me, a fellow private investor, then no money goes back to BUNS. It’s similar to if you buy a 1930s semi-detached house or a Van Goch painting – no money goes back to the builder or to the artist from these second hand purchases.

Only shares issued directly by the company brings money back to its own coffers.

After a while BUNS wants to expand. It could issue more shares to do so – raising more money by dividing itself up to increase the shares in issue to say 200,000 – but that would dilute existing shareholders and reduce the price of existing shares.

Many BUNS directors are also BUNS shareholders, and they don’t like the sound of that!

Instead it issues 100,000 bonds at £1 each. These bonds promise to pay the owner 10% interest every year for 10 years, at which time they will be redeemed by the company (cancelled) and anyone owning the bonds will get £1 back.

The bond issue raises £100,000. The company spends £60,000 of it on a new nappy shop in Chiswick – an investment in commercial property. It keeps the other £40,000 as cash in the bank for future investment. The annual interest due to the bondholders is paid from the company’s earnings.

After a while, managers get fed up with the price of their nappies going up due to rising raw material costs. They spend £30,000 to buy a special kind of share – an ETF – which tracks commodities like cotton. They hope that if cotton prices go up, reducing profits, it will be partly offset by the ETF price rising, too.

Business goes well, and soon BUNS is making millions. It can easily pay the interest on its bonds and also pay shareholders an increasing dividend.

Eventually success goes to the directors’ heads, and they decide they deserve to work in classier surroundings. They’re also a bit bored of the boring nappy business. They buy several trendy paintings by the graffiti artist Banksy for the office.

They tell shareholders that the paintings are an investment in alternative assets!

Asset classes and risks and rewards

Different asset classes have different risk versus reward traits.

We’ve already seen, for example, how cash is the safest asset class. The riskiest mainstream asset class is shares, but the rewards can be higher, too.

As we saw in lesson three, however, a lot depends on when you buy your assets.

Asset classes or sub-classes can become overvalued as a whole – think Spanish property in 2008 or Dotcom shares in 1999 – as well as undervalued.

But the risk/reward tends to follow this fun graph:

Asset classes and diversification

Note the difference between an asset class, and an asset within that class.

• Tesco and Barclays shares are both assets from within the same asset class.

• Cash you keep in a Barclays bank account is from an entirely different asset class.

Many new investors think they are well-diversified because they have a portfolio of 20 different companies.

But all those holdings are in the same class: Shares!

• Vertical diversification – Splits money between several different asset classes.

• Horizontal diversification – Hold different assets within an asset class.

To achieve a well-diversified portfolio, an investor first splits her money between different asset classes, and then further spreads it around by buying different assets with each sub-division.

For example, allocating 20% of your money to equities gives you exposure to the asset class of shares1. If you put that 20% into a UK index-tracking fund, it is then further spread across the many companies that make up the index. Choose a global tracker fund and it’s spread even more widely.

• Vertical diversification helps protect you from stuff like a stock market crash or a property slump – or from missing gains because all your money is in cash.

•  Horizontal diversification protects you from more local troubles, such as a company making a loss or a bond defaulting on the income it owes you.

The philosopher Francis Bacon had all this figured out 400 years ago, writing:

Money is like muck. No good unless spread.

By muck he means animal manure. Great if spread about to fertilize future crops. A potentially stinking liability if left in a pile in one corner!

Key takeaways

• There are only six main asset classes that you really need to know about.

• Cash, Shares, Bonds, Property, Commodities, Alternative Assets.

• Within each asset class are many different specific assets.

• Good diversification is spread between asset classes, as well as assets.

This is one of an occasional series on investing for beginners. You can subscribe to get our articles emailed to you and you’ll never miss a lesson! Why not tell a friend to help them get started?

1. Note: Equities is just a fancier word for shares. [↩]