Emerging Markets: Why Growth Doesn't Equal Returns

(MoneyWatch)  On Monday, we saw that fast economic growth doesn't translate into higher investment returns. There are a few reasons why this is the case.

First, markets incorporate the expectation of faster growth (be it growth of earnings or GDP) into prices. Remember that you can only benefit from information the market doesn't have. If you're aware that certain countries are expected to have faster rates of GDP growth, the market certainly knows it as well.

Second, the rate at which investors discount expected growth is based on risk -- the greater the risk, the higher the discount rate and the higher the expected return.

Therefore, the fact that emerging market countries are projected to grow faster than developed market countries doesn't mean that they should be expected to provide higher investment returns. So that leaves us with the question of whether we should invest in emerging market countries. While they might have higher GDP growth rates, we've seen that faster growth alone doesn't lead to higher investment returns. However, we do know that emerging markets are riskier places in which to invest.

For example, for the period 1988-2009, the annual standard deviation of the MSCI Emerging Markets Index was 37.5 percent. This is 94 percent higher than the 19.4 percent standard deviation of the S&P 500 Index and 75 percent higher than the 21.4 standard deviation of the MSCI EAFE Index.

That kind of volatility can raise the level of stomach acid to an unacceptable level. And the volatility of individual countries within the MSCI Emerging Markets Index was much greater. The much greater risk, as indicated by the much greater volatility, should mean higher expected returns. Thus, the higher expected returns are not a free lunch; they're compensation for taking incremental risks.

Tomorrow, we'll see how the higher risk and expected returns of emerging markets affect a portfolio.

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?