How to Overcome Three Psychological Barriers to EM Investing

Despite many emerging markets stocks’ currently attractive valuations and diversification potential, many US-based investors continue to underweight the emerging world in their portfolios. Of course, with recent rallies in the domestic stock market, there has been less impetus to look beyond the familiar neighborhood of US equities.

However, there may be more at work here. Theories from behavioral finance may also shed some light on why many investors tend to shy away from Emerging Market (EM) investments. In our view, there are three main psychological barriers keeping many investors on the EM sidelines – but the good news is that they can be overcome.

Home country bias

This behavioral finance concept describes a widespread investor mistake: over investing in one’s own country, as Russ Koesterich has aptly described it. For Americans, this means over allocating to U.S.-based securities. Potential explanations for this bias include people’s tendencies to prefer what’s familiar and consequently being too optimistic about their home markets.

Just being aware of this bias can help investors overcome it, as can learning more about EM investments. ETFs may offer an entry point to EM worth considering, since they offer ease of access and diversification that would be difficult for most investors to assemble by researching individual securities in unfamiliar markets. With EM ETFs, as with any investment, it’s a good idea to familiarize oneself with the funds’ country and sector breakdowns, largest holdings (which often are global companies) and other key fund information by reading the fund’s website, prospectus or shareholder reports.

Myopic loss aversion

According to this behavioral finance notion, people feel the pain from losses much more acutely than they feel the joy from similar size gains, and they tend to evaluate returns over a relatively short time period. These tendencies can lead investors to seek to avoid short-term losses – so any recent, easily-recalled volatility in EM makes it look particularly unappealing.

To tackle this bias, investors need to become more comfortable with the downside risks of EM investing. One way to do this is to think about EM investments as part of one’s overall portfolio, rather than just looking at them in isolation. Riskier equities may seem less like isolated gambles when they’re considered in a broader portfolio diversification context, given that they aren’t usually perfectly correlated with other assets (hence why they can help diversify a portfolio!).

In addition, thinking about portfolio performance over the long term, and checking in with your portfolio periodically rather than continuously, can help investors stay focused on their ultimate investing goals. While stock markets can be highly volatile over short horizon, time tends to smooth out these fluctuations.

Personal experience biases

Finally, when investors form their preferences, or likes and dislikes, and expectations about future returns and risks, they tend to overemphasize their own past personal experiences at the expense of all available information. This barrier can be especially damaging to the portfolios of today’s younger generations of investors, Gen X and Millennials, who, over the past 15 years have seen two big stock market crashes and therefore may be especially apprehensive of investing in riskier assets like EMs.

There are some things investors can do to combat these biases. For instance, investors should make sure they’re looking at market performance over long time periods and under different macro and market scenarios. But sometimes, just knowing that we’re all susceptible to these kind of cognitive short-cuts can go a long way towards making sure that you don’t fall into easy habits and potentially miss out.