This question originally appeared on Quora.
Answer by Yair Livne, econ Ph.D. from Stanford:
Investing in developing countries carries some specific risks that may deter the average investor from allocating the majority of his or her portfolio to investments in those countries. These risks translate into lower risk-adjusted return on investment than what the country's growth rate might suggest, which explain why these kind of assets do not make up majority of most recommended portfolios. This is a partial list:
Regulatory risk: In many developing countries investment carries risks relating to government and the rule of law. This can take many forms:
• Nationalizing foreign investment: Countries like Venezuela have nationalized foreign investments in their countries, or severely tax those. This can virtually wipe out an investment overnight.
• Arbitrary or unexpected taxation: For example, the Indian government recently proposed a retroactive tax on foreign takeovers of Indian assets, mainly targeting Vodafone which has been in dispute with the government. This specific move may not be directly related to personal investment in developing markets, but is a good example of how unpredictable the tax environment can be in such markets.
• Corruption: Governments and related bureaucracies may be very corrupt, requiring bribes to allow business to operate smoothly. This will take a toll on the investment, just like a tax.
• Weak or biased legal system: Say the target of your investment cheats you as an investor or you end up involved in a legal procedure as investor. Often your position there is very different than what you would expect form a court in a developed country. It may be much easier for the local firm to avoid compensating you, disappear with your money etc.
Instability: Beyond mere regulatory risks, many developing countries live in unstable areas or are still actively involved in internal and external conflict. Revolutions, coups and wars can and will happen in some of these countries over the lifetime of your investment, which will take a toll on returns.
Underdeveloped financial markets: In many developing countries the available portfolio of investment (as the question suggests) is not necessarily representative of the country's economy. This is often due to economies where most companies are not public (or even government-owned). This makes an investor's ability to track an economy's growth difficult.
Lack of information/Weak regulatory environment: Even when financial markets exist, they might often be underregulated or misregulated and may not resemble ones in developed countries. Accounting standards may be weak, fraud prevalent, or like in China's case, the government might be actively encouraging firms to hide negative information about their performance. All of these hinder an investor's ability to construct a reasonable portfolio.
High correlation across markets: Despite the seemingly diverse geographical location of fast-growing developing economies, the reality in today's ultra-linked markets is that returns are highly correlated across economies. Thus, much of the diversification that such investments used to offer is no longer there.
FOREX risk: Any investment in a foreign market exposes you not only to risks associated with that particular investment but also to the risk coming from investing in another currency. Assuming that you want your returns in U.S. dollars, you are essentially also betting on the exchange rate when investing in a foreign company. This risk is dramatically higher when the investment is in a developing economy. Hedges can be used to limit exposure to this risk, but that insurance costs money, and cuts into returns from the investment.
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