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Emerging Markets? No, Thank You! (Part 1 of 4)

|Includes: Berkshire Hathaway Inc (BRK.A), BRK.B, BYDDF, BYDDY, WSC-OLD

With many of the major economies around the world on the ropes, emerging markets ("EM") have been garnering a good amount of attention and investors' monies.  With growing economies, an ongoing shift in global trade trends with more emerging countries engaging in commerce amongst themselves and the internet instantaneously diffusing technology and knowledge at little cost around the globe, these markets are almost assured to grow more important.  Does that mean Western investors should invest in these markets?  Probably not.

Academic research, in simplified form, suggests that investors find a great number of investment opportunities and, to ensure they don't correlate with each other, have them be as disparate as possible.  This premise leads academics and investment promoters, amongst others, to suggest that investors allocate a portion of their portfolios to emerging markets (and recently also to the latest fad, "frontier markets" or those not in the MSCI EM Index).  Failure to do so is derisively called "home bias" which implicitly suggests that investors are being affected by a psychological maladie.  In this four-part blog post I'll explain why this is not the case and why staying close to home is often better than venturing afar.

Home is Where the Money is

Herbert A. Simon, a Nobel Prize winning economist, psychologist, educator, computer scientist, pioneer in artificial intelligence and all-around renaissance man, coined "bounded rationality" as a phrase describing how we humans pragmatically make decisions.  In essence, we make decisions based on what we know, not on what we could optimally know, to make the "best" decision (en.wikipedia.org/wiki/Bounded_rationalit...; Hence what seems "irrational" to one is fully rational to another because of the latter's knowledge bounds.  While this oversimplification seems too obvious to win a Nobel Prize, it nonetheless gets ignored by investors and economists nearly everyday.  Think about "optimal capital structure", "optimal portfolio allocation", or "optimized decision making" for examples. Long Term Capital Management ultimately failed while attempting to make "optimal" portfolios.

For a professional investor in the mutual fund capital of Boston to know what is happening in China's political capital Beijing, there is much she needs to appreciate, even if she were born there but spent the last 10+ years getting immersed in Western education and culture.  Her bounds of knowledge of China may be wider than a native Westerner who goes for one or two business trips a year but it almost certainly will be narrower than her local counterpart.  Simon's Travel Theorem also applies here (he posits that "Anything that can be learned by a normal American adult on a trip to a foreign country (of less than one year’s duration) can be learned more quickly, cheaply, and easily by visiting the San Diego Public Library."  This was even before the internet.).

In addition, there is the social dynamics of EM that investors usually are either not cognizant of or too heavily discount partly because of its complexity.  In many of these markets, a small ethnic minority often dominates the nation either politically or economically and in extreme cases both.  This almost always leads to quietly harbored resentment and then oftentimes to violence or policies with poor consequences or both.  There are unfortunately too many recent examples of this such as Indonesia's and Russia's ethnic pogroms and persecutions against certain minorities; and Zimbabwe's and South Africa's appropriations or "redistributions" to their majorities.  In accord with the Travel Theorem, while these unfortunate events simmer before they boil, the New York Times may report it but analyst research reports or management meetings in an office tower or plant or a few days trip in a nation seldom yields such insights.  Hence when the boil comes investors are "surprised" though they need not be.

Staying "home", you know the score before the first pitch.  It usually gives an investor that knowledge advantage that another local has in his own market.  It's no wonder why VCs and other professional investors focused on management in startups almost alwyas restrict their investments to local firms even going so far as to limit which states they invest in.  Common stock investors should consider the insight of these investors perfectly rational.

In the next blogpost, I'll explain why staying close to home leads to a better investment experience than sending capital to exotic locales better known to most on Thomas Cooke brochures.

Disclosure: The author owns no common shares in any of the aforementioned companies.