Stocks · Intermediate · 5 min

International and emerging markets

You can explain how markets are classified as developed, emerging or frontier, and name the extra risks of investing abroad, especially currency risk.

Your country, a small slice

Most people invest mainly in companies from their own country. They know the names, read the news and use the products. It feels natural.

Yet for most countries, their stock market is only a small slice of the world's. Investing abroad opens up many more companies and economies. It also adds risks that do not exist at home, and the further you go from the largest markets, the larger those risks become.

Developed, emerging, frontier

Index providers group countries into three broad classes. MSCI's framework uses three criteria: economic development, the size and liquidity of the stock market, and market accessibility, which covers openness to foreign investors, the free flow of capital, and how well the market's rules and institutions work.

Developed markets have large, liquid stock markets that are open to foreign investors. The MSCI World covers 23 of them.
An emerging market has a growing economy and a sizeable stock market, but more limits on foreign investors, less stable institutions or less liquidity. Prices usually swing more.
Frontier markets are smaller still, harder to access and thinly traded.

Investing abroad adds several risks:

Currency risk. Currency risk is the chance that exchange rate moves change your result. A foreign share is priced in its own currency. If that currency falls against yours, your result falls too, even if the share price rose.
Political and legal risk. Changes in government, regulation or taxes can hit foreign investors directly.
Access risk. Some countries limit foreign ownership or control how money leaves the country. In a crisis, these limits can tighten.
Costs. Currency fees and foreign withholding taxes reduce returns, as the rubric on accounts showed.

Many investors still hold far more domestic shares than their country's weight in the world market. This tendency is called home bias. It concentrates risk in one economy and one currency.

+10% share, −8% currency

A euro investor buys a US share for 10,000 euros, which converts to dollars at the day's rate.

After a year, the share has risen 10% in dollars.
Over the same year, the dollar has fallen 8% against the euro.
Converted back, the investment is worth about 10,000 × 1.10 × 0.92 = 10,120 euros.

The share gained 10%, the investor about 1.2%, before currency fees. In a year when the dollar rises instead, the effect works the other way and adds to the gain. Some funds hedge currency risk, which reduces this effect at a cost. Over a few years, currency moves can be large, and nobody can reliably forecast them.

Common mistakes

Ignoring currency moves. They can be as large as the share's own move.
Equating fast economic growth with high stock returns. Profits, valuations and currencies decide returns too.
Assuming a world fund includes emerging markets. The MSCI World does not.
Investing only at home. Home bias puts many eggs in one basket.

The takeaway

Investing abroad spreads risk across economies, but adds currency, political and access risks. Emerging markets carry more of all three.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the group that the MSCI World covers.

Tap the chart.

The MSCI World contains only developed markets. Emerging markets have their own indices.
2A US share rises 10% in dollars. The dollar falls 8% against the euro. What is the result for a euro investor, roughly?

1.10 × 0.92 ≈ 1.012. The currency move ate most of the gain.
3Which criteria does MSCI use to classify a market?

MSCI's framework combines these three. Accessibility includes openness to foreign investors and the free flow of capital.
4What is home bias?

Many investors hold mostly domestic shares, even when their country is a small part of the global market.

of 4 correct.