Finding the Sweet Spot of Investing

Reduce a portfolio’s risk without giving up on high returns

Investing1Ask any number of investors what they want out of a particular stock, bond, or mutual fund and you’re likely to get the same answer: low anxiety and high returns. But all too often, big investment rewards come with immense risks, and these days, great nervousness. There is a solution, however. To find the proverbial sweet spot—substantial profits with bearable volatility—today’s investors need to spread their bets, and do it shrewdly.  What follows is a collection of investments that can help to minimize the chance of losses while maximizing your portfolio’s earnings.

Emerging Market Bond Funds

The emerging markets of the world are natural places to look for growth. As more citizens of China, India, Russia, Brazil, and elsewhere continue to attain a middle-class standard of living, economic growth in these countries will soar. In 2009, for instance, while the U.S. struggled to get out of a recession, the Asian Development Bank reported that the region’s economy proved to be more resilient than expected in its response to the global financial crisis. The bank projected economic growth at a 3.9% pace for 2009 and 6.4% in 2010. This compares to the Federal Reserve’s U.S. forecasts of a contraction of -1% to -1.5% for 2009 and growth of 2.1% to 3.3% for 2010.

With such growth also possible in other developing markets around the world, participating investors are likely to prosper. Sure enough, Morningstar reports that emerging markets stock funds returned 10.51% per year for the past 10 years, through the third quarter of 2009, among the best of all mutual fund categories. By contrast, U.S. domestic stock funds returned a scant 2.46% a year. There is however, one catch. Emerging markets stock funds are volatile. In the crash year of 2008, this sector lost nearly 55% of its value, a far steeper loss than U.S. stock funds suffered.

So, how can you pocket profits while reducing risks? Mix your emerging markets stock funds with funds that hold bonds issued by emerging markets governments and companies. Over the past decade, emerging markets bond funds have posted annualized returns of 10.74%, slightly higher than their cousin stock funds. Emerging markets bond funds certainly have risks (they lost almost 25% in 1998 and nearly 18% in 2008) but they have not been nearly as volatile as the stock funds. “Ideally, you should hold both emerging markets stock funds and bond funds,” says Tom Idzorek, chief investment officer and director of research and product development at Chicago-based Ibbotson Associates, a Morningstar company.

“If you have an emerging markets stock fund and a bond fund, you are likely to have a smoother ride, long-term, than if you have only one type of fund.” However, he warns that investors shouldn’t load up on emerging markets stocks or bonds, expecting the high returns of recent years. “Perhaps 10% or even 5% of a diversified portfolio should be in the emerging markets,” he says.

Top-Performing Emerging Markets Bonds Funds*

moneywise chart2

*Based on total annualized 5-year returns, through 9/30/09 (click to enlarge)

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