The benefits of diversification come from more than just return. When two asset classes move up and down at different times and different rates, these swings tend to offset one another, making a smoother ride without detracting from performance.
Emerging markets stocks have been particularly valuable for this. In six of the years in this study, the difference between returns for the S&P 500 and emerging markets was more than 40 percentage points. (In 1993, the difference was more than 70 percentage points.)
The figures I’ve used so far for emerging markets represent a large-cap blend index of growth and value.
However, just like the U.S. and international markets, emerging markets stocks can be (and are) segregated by company size (large-cap, midcap and small-cap) and by value orientation.
And just as value trumps growth in the international and U.S. stock markets, emerging markets value stocks outperformed emerging markets large-cap blend stocks over the past 26 years. The score: emerging markets large-cap blend 11.3% (as noted above), emerging markets value 14.3%.
That difference would have more than doubled the gain from an initial $100 investment: $1,517 in large-cap blend versus $3,112 in value.
Also just as we would expect, small-cap emerging markets stocks outperformed large-cap ones, with a compound return of 12.5%.
Emerging markets have higher long-term expected growth rates than developed markets, and they are more risky. That additional risk is built into the prices of the stocks.
The price/earnings ratio of large-cap blend emerging markets stocks is 13, considerably lower than the P/E ratio of 18 for the S&P 500.
In this article I’m advocating emerging markets as a way to diversify a portfolio that also includes the S&P 500.
To that purpose, I calculated the results of a portfolio split as follows: 50% in the S&P 500 and one-sixth each in emerging markets large-cap blend, emerging markets small-cap and emerging markets value.
With that mix, an initial investment of $100, rebalanced annually, would have grown to $1,903. (That compares with $1,306 for the S&P 500 alone and to $1,617 for the emerging markets large-cap blend alone.)