In an article for ETF.com, BAM Alliance director of research Larry Swedroe points out that, despite the attractive valuations and growth outlooks for emerging market stocks, most U.S. investors dramatically underweight this asset class in their portfolios.

According to Swedroe, the underweighting is primarily the result of two mistakes by investors:

• Country bias: Swedroe writes, “investors tend to believe that not only is their home country a safer place to invest, but it will produce higher returns—defying the basic financial concept that risk and expected return are related.”
• Recency bias, in which investors allow more recent returns to influence their decision-making.

Swedroe argues that investors tend to exhibit behaviors that are destructive to returns, which he illustrates using the concepts of “convex” and “concave” investing behavior:

Individual investors, writes Swedroe, “tend to be performance chasers,” a problem compounded by their short memories. “It wasn’t long ago that investors were piling into emerging market equities due to their strong performance,” he writes, adding, “For the five-year period 2003 through 2007, while the S&P 500 Index provided a total return of 83%, the MSCI Emerging Markets Index returned 391%.”

Swedroe offers insights regarding the importance of the price-book ratio in emerging markets, highlighting that “expected returns among emerging market equities are now much higher than they are for U.S. stocks” and driving the point that the case for EM is “even more compelling” for value investors.

Global diversification, Swedroe writes, came under scrutiny after the financial crisis when “all risky assets suffered sharp price drops…When that happened, many investors surmised that global diversification doesn’t work because it fails when its benefits are needed most.” He explains, however, that focusing on the fact that a globally diverse portfolio doesn’t insulate investors from short-term downturns misses the larger point that “investors whose planning horizon is long-term (and it should be, or they shouldn’t be invested in stocks to begin with) should care more about long, drawn-out bear markets, which can be significantly more damaging to their wealth.”

Swedroe concludes that bearing the political, market and currency risk associated with emerging markets is the “price” investors pay for earning an expected long-term return premium, adding, “Current valuations suggest that U.S. equity investors are likely to be disadvantaged if they under allocate to emerging market stocks.”