Emerging Markets: The Relationship Between Growth and Returns

(MoneyWatch)  Lately, there's been a lot of press about the expectation for faster economic growth from emerging markets such as the BRIC countries (Brazil, Russia, India and China). These stories imply that faster growth means superior investment returns for you. It's almost like this is becoming conventional wisdom. But before you act, you should take a look at the evidence. This provides another example that that the conventional wisdom on investing is often wrong.

Whether we are talking about stocks or countries, the idea that higher future growth means higher investment returns is incorrect. For example, while growth companies experience faster earnings growth than value companies, value stocks have historically produced higher returns than growth stocks.

Also (and this may surprise you), there's a negative correlation between GNP growth rates and investment returns. There's simple logic for the negative relationship. Faster growth reduces the risks of investing, causing the equity risk premium to shrink. However, we don't have to rely solely on logic.

Thanks to research by Elroy Dimson, Paul Marsh and Mike Staunton (authors of Triumph of the Optimists), we have evidence on the relationship between GDP growth rates and investment returns. The authors measured portfolio performance of 83 countries based on historical GDP growth. For the period 1972-2009, the lowest growth countries provided an investment return of 25.1 percent per year, outperforming the fastest growing countries by almost 7 percent per year.

Not only did the slower growing countries provide higher returns, they also produced higher Sharpe ratios (measure of risk-adjusted returns). The slowest growing countries produced a Sharpe ratio of 0.85 versus 0.69 for the fastest growing countries. So much for conventional wisdom.

On Wednesday, we'll discuss why this is the case.

Follow the series: Emerging Markets

• Part one: The Relationship Between Growth and Returns
• Part two: Why Growth Doesn't Equal Returns
• Part three: How the Asset Class Affects the Portfolio
• Part four: Can They Lower Volatility?