From 2008 through 2015, the S&P 500 Index returned 6.5% per year, providing a total return of 66%. During the same period, the MSCI Emerging Markets Index lost 2.8% a year, providing a total return of -21%. It managed to underperform the S&P 500 Index by 9.3 percentage points a year, and posted a total return underperformance gap of 87 percentage points.
Not only were investors earning much lower returns from emerging market stocks, they were experiencing much greater volatility. While the annual standard deviation of the S&P 500 Index was about 21%, the MSCI Emerging Markets Index experienced volatility of about 38% a year. Not exactly a great combination—lower returns with almost twice the volatility. What’s to like?
EM Underperformance Continues
And the start to this year hasn’t been any better. The performance gap has widened a bit further as, through Feb. 24, the S&P 500 Index lost 5.3%, while the MSCI Emerging Markets Index lost 6.6%.
The comparisons get even worse if we look at the latest five-year returns. For the period ending Feb. 24, 2016, Vanguard’s 500 Index Fund (VFINX) returned 10.3% per year while its Emerging Markets Index Fund (VEIEX) lost 5.2% per year, a performance gap of 15.5 percentage points per year.
Unfortunately, it’s been well-documented that individuals have a strong tendency to invest in a manner destructive to their returns. The illustration below depicts the difference between “convex” and “concave” investing behavior.
While investors know that buying high and selling low isn’t a good strategy, the research shows that individual investors tend to buy after periods of strong performance (when valuations are higher and expected returns are thus lower) and sell after periods of poor performance (when valuations are lower and expected returns are thus higher).
Research has found this destructive behavior has led to investors managing to underperform the very funds in which they invest. What’s the explanation for this irrational behavior?
Among the 77 errors discussed in my book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” is one called “recency.” Recency is the tendency we have to overweight recent events/trends and ignore long-term evidence. This can result in behavior opposite to what a disciplined investor should be doing (rebalancing) to maintain their portfolio’s asset allocation. Disciplined rebalancing produces the concave strategy.
The problem created by recency is only compounded when emerging market stocks are the underperforming asset, because such situations greatly increase the risk that an investor will make an error. The reason for this is another of the 77 mistakes I cover. Confusing familiarity with safety can lead to a home-country bias.