Join our community of smart investors

When to buy emerging markets

There's a good rule that gives us a clue: the 10-month average rule. This tells us we should buy when prices are above their 10-month average and sell when they are below it. This rule works for US and UK equities, for gold and for bubble-prone sectors. It should not, therefore, be a surprise that it also works for emerging markets.

My table shows the point. It shows what would have happened if you had followed this rule for the MSCI emerging market index since December 1990. At the end of each month, you buy the index if it is above its 10-month average, and you hold one-month dollar deposits if it is below it.

Emerging market returns since December 1990
10-month ruleBuy & hold
$100 grown to:906.5428.9
Annualised return9.26.0
Standard deviation14.722.9
Sharpe ratio0.630.26
Worst month-12.8-29.3
Worst 12 months-28.6-57.6

This strategy would have turned $100 into more than $900 by now (ignoring dealing costs, although these should be low for exchange traded funds) - double the return from a buy-and-hold strategy. What's more, because our rule got us into cash sometimes, it achieved these returns with less volatility. Because of this, the Sharpe ratio for the rule is more than twice that for the buy-and-hold strategy. And the worst losses under the rule are only half as nasty as the worst losses suffered by buy-and-hold.

The rule succeeded because it often got us out of emerging markets before some nasty losses. For example, it got us into cash between August 1997 and March 1999, thus saving us from a 31 per cent loss. It got us out of the market between May 2000 and December 2001, preventing a 26 per cent loss. It got us into cash in June 2008 saving us from a 25 per cent drop. And it got us out of the market in late 2014, saving us another 20 per cent.

The rule's success is evidence that emerging markets are prone to momentum. When falls lead to further falls, and rises to rises, then the 10-month average rule works well. By contrast, it fails when 'buy on dips' strategies work.

Of course, the rule isn't perfect: nothing is. When prices are a long way above their 10-month average, they can fall some way before triggering a sell signal and so we'll lose money: this happened in 2007-08 for example. And if markets stage sharp V-shaped recoveries the rule will cause us to miss the first leg of any recovery. Right now, for example, emerging markets could rise 13 per cent before triggering a buy signal.

Following this rule, therefore, means it's likely that you'll miss out on some profits. This is the price we must pay for the fact that the rule protects us from the risk that herd behaviour will cause markets to fall even further.

Is this price worth paying? My instinct is that it is. We can't catch every penny. In an uncertain world we should try to satisfice rather than optimise. This simple rule is one way of doing so.