Specifically, emerging markets like China and Brazil have plenty of opportunities, as does non-BRIC (Brazil, Russia, India, China) countries like Bangladesh and Dubai. I wrote a story on emerging economies for Canadian Business magazine on where you might be able to find cheap investments, and why the market’s valuation is relatively low these days.

There are two main reasons why a lot of investment managers like emerging markets. The first is that people are still concerned about the global economy, so they’re not eager to jump into a market that’s not their own. Investors see developing countries as risky, and it’s hard to blame them. Most Canadians don’t know a heck of a lot about China, and especially not about smaller countries like Bangladesh or Nigeria. Political climate is also a concern. One portfolio manager I spoke to in the story doesn’t invest in Russia — he says the “political agendas” make it difficult for corporations to run effectively. However, another manager has no qualms about investing in the country. The risk and uncertainty makes valuations cheap.

Another reason why emerging markets are, generally, a good place to invest is because they have a low debt-to-GDP ratio — around 40% compared to 80% to 120% for developed countries. (This, of course, is a pretty sweeping generalization — debt-to-GDP can vary wildly depending on the country, but this is still a useful comparison.) Emerging markets had debt-to-GDP problems years ago, which caused fiscal defaults in a number of countries. But, many world leaders have learned from past mistakes and have made a concerted effort to avoid the issues they faced in the past.

According to Mark Mobius, executive chairman of Templeton Asset Management, emerging markets will grow four times faster than developed countries in the coming years. That’s a pretty big number and yet another reason why you may want to capitalize on this space.

Buying into emerging markets is fairly easy. Most mutual fund companies offer global funds and emerging market funds (the most popular of which invest in BRIC). There’s also country specific funds, like a China fund, and while it’s rare right now, you can invest in Frontier funds, which cover countries in Africa, the Middle East and some up-and-coming European and Latin American locales. (This latter category is risky — it’s not recommended that a newbie investor buy into something like this until they’re better versed in non-domestic investments.)

Whether you want to start investing outside of Canada or not, it’s worth looking at other markets. Domestic markets will hopefully continue to rise, but if you want to see your money grow a bit faster, you may have to look beyond this country’s borders.

Read my Canadian Business story and find out more about emerging markets.

Where in the world should you invest? The globe is a big place, and faced with dozens of countries to choose from it’s easy to get overwhelmed. Luckily, MoneySense is here to help. We’ve done the dirty work for you and crunched reams of hard data to come up with the top markets to invest in today.

Because there tends to be a big difference between emerging and developed markets, we decided to evaluate them separately. We first focus on the developed world and then explore emerging markets. But in both cases we evaluate countries (as represented by their country-specific exchange-traded funds, or ETFs) in two ways. First, we look for those that represent good values relative to their fundamentals. These are value markets which appeal primarily to investors with a longer-term outlook and a penchant for lower risk situations. Second, we highlight markets with momentum. Here we seek strong recent return patterns that appeal to action-oriented investors.

“Believe it or not, this wouldn’t actually bother me so much,” Buchanan continued, “if I hadn’t bought Jacob Internet Fund in January 2000. I got my guts ripped out by that fund.” (Jacob Internet lost 79.1% in 2000, another 56.4% in 2001, and 13% more in 2002.) “So I sold it at the end of 2002. As soon as I got out, the damn thing turned into a superstar.” (Jacob went up 101.3% in 2003.)

“Why does this keep happening to me?” asked Buchanan plaintively. “I know—I don’t think, I KNOW—that the second I sell my emerging markets fund, it will take off. But if I keep it, it will keep losing money! What’s wrong with me? What should I do? Is it Murphy’s Law of mutual funds?”

Buchanan emailed me because of a column I had written in 2002 called Murphy Was an Investor. In our daily lives, we all shake our heads over the apparent workings of Murphy’s Law (“Whatever can go wrong will go wrong”) and its corollary (“. . . in the worst possible way at the worst possible time”). We tend to believe that it will rain if we forget our umbrella and be sunny if we lug it along,  or that whichever checkout line we stand in will turn out to be slowest, or that whenever we change lanes on the highway the other lanes will speed up. But does the perverse logic of Murphy’s Law govern investing, too? And is the whole concept merely a cleverly expressed superstition, or does it have some basis in fact?

The maven of Murphy’s Law is an Oxford trained physicist named Robert A. J. Matthews. A few years ago, Matthews set out to investigate one of the oldest examples of Murphy’s Law: Why does bread always seem to land butter-side down when it falls on the floor? You might think it’s because the buttered side is heavier; a psychologist might say we are more apt to recall a wet landing than a dry one; a skeptic might simply insist that which way the bread lands is random. It turns out all those views are wrong.

“Like most people, I guess,” says Matthews, “I thought it’s a 50/50 chance, unless you’ve got a pound of jam on one side.” With the uniquely British gift of taking essentially silly things very seriously, in 2001 Matthews enlisted 10,000 schoolchildren across England to tip buttered toast off plates. Just over 62% of the time, the bread landed butter first—a percentage much too high, across so many trials, to be the result of chance. Matthews easily ruled out the weight of the butter as a cause: When unbuttered toast was inscribed with the letter B in magic marker, then placed face-up on a plate and tipped off the table, it landed B-side down most of the time.

So why does toast tend to go splat on the wrong side? “The universe is designed against us,” Matthews says flatly. Given the width and velocity of falling bread and the typical height of tabletops, there isn’t enough room for a tipped piece of toast to make a full rotation before it hits the floor. And tabletops are so low because humans average less than six feet in height.

That’s what engineers call a fundamental design constraint. Does investing have its own design constraints? Of course it does. From the beginning of 2003 through the end of 2005, emerging markets gained an average of 36.3% annually. But decades—in fact, centuries—of history show that economic growth of greater than 2.5% to 3.5%, after inflation, is not sustainable. In the short run, stock markets can perform better than the economies they represent and the companies that make them up. In the long run, it’s impossible. A period of unusually high returns must be followed by more normal returns. That’s why the Japanese stock market, after its record-setting returns in the 1970s and 1980s, lost roughly two-thirds of its value in the 1990s. It’s why the U.S., after the boom of the late 1990s, suffered the bust of 2000 to 2002. And it’s why emerging markets, after years of scorching gains, were not a good choice to throw money at in early 2006. At that point, the only question was not whether they would lose money, but when. (I told Michael Buchanan to sit tight and, in fact, emerging markets went on to have a good year overall in 2006. But I reached Buchanan too late; he had already sold.)

The pursuit of extreme growth carries within it the seeds of its own destruction. As Warren Buffett quips, “Nothing recedes like success.” That brings us to Murphy’s Law of Investing: sooner or later, a stock or fund return that is much higher than average almost always fades back toward average. By the same token, a badly below-average return is also liable to reverse.

This tendency for trends to flip with the passage of time is called regression to the mean. Without it, giraffes would get taller with each passing generation until their hearts and hips burst under the strain. Big oak trees would drop bigger acorns, yielding larger and larger saplings until full-grown trees collapsed of their own height and weight. Tall people would always have even taller offspring, and so would their kids, and so on, until no one could get through a nine-foot-tall doorway without ducking.

Regression to the mean is nature’s way of leveling the playing field, in almost every game, including investing. So, whenever you gamble that a very high (or low) investment return will continue, the odds are overwhelmingly against you. Michael Buchanan should have been betting on regression to the mean; instead, he bet against it. By constantly grabbing the hottest returns he could find, he virtually guaranteed that he would get scalded sooner or later.

Other aspects of Murphy’s Law apply to investing. Robert Matthews points out that a great Cambridge mathematician, G. H. Hardy, believed in Murphy’s Law of Umbrellas. “Hardy was convinced that there is a malevolent rain god,” says Matthews, “so he would send an assistant outside carrying an umbrella to trick the god and ensure that it wouldn’t rain on Hardy’s cricket match that day.” Even in soggy England, however, the odds that it will rain during any given hour of the day are only about 10%. So, even when the forecast is for a 100% chance of rain that day, the odds of rain at any particular hour are much lower. Therefore, most of the times you lug an umbrella because of a rainy forecast, you will end up never opening it. And the more often you tote an umbrella around under a sunny sky, the more likely it is to stick in your selective memory. You will be much less inclined to remember the less common cases when you brought your umbrella and it did rain. As a result, you will tend to overestimate how often you carried an umbrella in vain, and to underestimate how often you didn’t bring it when you should have.

Likewise, whenever one sector of the stock market is hot, diversifying your money across other assets will always feel like a waste of effort—an umbrella you never seem to need. As Michael Buchanan’s story shows, however, it is a mistake to think you don’t have to be diversified. No matter how many times you carry an umbrella without needing it, you will be very glad indeed to be carrying one when a downpour finally hits.

Your apparent tendency to pick the wrong checkout line holds an investing lesson, too. If three cash registers are open, the odds that you will pick the fastest line are only 33%. Two-thirds of the time (assuming the same number of people are waiting and the checkout clerks are about equally efficient), one of the other lines will move faster. With four lines open, your odds drop to one in four. So the raw math is always against you: No matter which line you pick, it will usually be the wrong choice. You may think your success rate is a function of how well you size up lines, but in fact it’s predetermined.

Now consider mutual funds. On average, over time, half the funds will do better than the market and half will do worse—before expenses like trading costs,  management fees, and taxes. After expenses, the odds of sustained outperformance go from 50/50 to about one in three. Thus, if you try picking mutual funds that will beat the market on the basis of their past returns alone, you will end up wrong about two-thirds of the time. That’s why intelligent investors don’t make that mistake.

The regret you feel from chasing a hot fund or stock becomes even more painful when you hear strangers boasting about their successes—on television, online, at the next party you go to. You screwed up, but somehow they keep making money. It’s that same uncanny feeling you get after you switch lanes on the highway: As soon as you move out of the “slow” lane into the “fast” lane, the fast lane turns into a parking lot. Whichever lane you are in is the wrong one—or so it seems. The truth is more subtle: when the other lane is slow, you can pass many vehicles in a blur, so you have only a vague sense of how many you have passed. But when your own lane is slow, one car after another passes you in a discrete whoosh. What’s more, safe driving requires you to focus more of your attention on the road ahead than on what is in your rearview mirror. So you get a much better and longer look at the cars that have passed you than at the ones that you yourself have passed.

With investing, too, your losers, and other people’s winners, can often feel more visible than your own good decisions. At a cocktail party or a barbecue, it might seem as if everyone but you has a great investing move to brag about. As you sheepishly excuse yourself to get a refill, it might not occur to you that all these folks made investing mistakes, too, and that a party is the last place they would ever discuss them. This mistaken feeling of being the only one with investing regrets can tempt you into taking risks you normally would avoid. It’s important to remember that everyone makes mistakes, and that everyone who makes mistakes has regrets.

With investing, there are two basic kinds of mistakes. The first is instantaneous and infuriating: you buy and the price tanks, or you sell and the price soars. You instantly know you did something wrong, and you immediately kick yourself.

The second kind of mistake is not obvious at first. While you’re lying on a towel at the beach, there is no single moment when you can look at your skin and see it turn from a healthy bronze glow to the neon red of a painful sunburn. A burn occurs so gradually that the transition is invisible. An investment mistake is often like a sunburn: it results from forgetfulness, carelessness, or creeping commitment to a choice that you may never have been happy about. But after the fact there’s no mistaking it, and it can burn like hell, and you’re sorry you did it.

The more an outcome appears to be the result of your own choice and the more readily you can imagine having done something different, the more painful your regret is likely to be. So, whenever possible, do as little as possible. Instead of making judgments one at a time, you should follow policies and procedures that put your investing decisions on autopilot. Think of it as cruise control for your portfolio. In 1995, I got a speeding ticket driving my in-laws’ car—and was so mortified that I swore I would never get another. Ever since, whenever I get on a highway, I check the speed limit and set my cruise control—eliminating all worries that I will get careless or emotional and end up speeding. “The more you can automate your investing,” says psychologist Thomas Gilovich of Cornell University, “the easier it should be to control your emotions.” Here are three forms of investing cruise control.

Have rules for ruling things out.

It was easy in 2006 to be angry that you didn’t put all your money into energy stocks right before oil prices blew sky-high: “I knew it!” But you are less likely to feel regrets later if, at the time, you followed rules for ruling investments out.

What are some good rules? Never buy a stock simply because it’s been going up in price. Never put more than 10% of your money into any one company. And never put your money into any stock or fund that you’re not willing to hold for at least five years.

Sticking to a few simple guidelines for why not to buy enables you to look back and say, “I didn’t put all my money into energy stocks because I would have had to break my own investing rules.  That wouldn’t have felt right. Sooner or later, it’s bound to be a mistake.” This way, you make an impulsive decision feel like a bigger departure from your normal behavior, so you are less likely, when you look back, to regret not having acted on that impulse.

Get Help pulling the trigger.

Because it can be so hard to sell a hopeless loser, you may need to get used to the idea. If you’ve re-examined your original reasons and concluded that an investment truly was a mistake—but you still can’t face getting rid of it—then you need a push. Psychologist Robin Hogarth of Pompeu Fabra University in Barcelona suggests changing the log-on password for your brokerage account to something like “dumpmylosers.” Typing that reminder every time you check on your account, puts you in the position of a musician who practices constantly. The idea of selling losers will become second nature to you; as you internalize it, you will become more comfortable with the need for action.

Writers, engineers, and graphic designers all know that the best way to spot their errors is to have someone else look over their work. A few money-management firms make it mandatory for each investment holding to be reviewed by someone other than the person who bought it; banks can reduce their losses by having bad loans re-evaluated by someone other than the executive who first authorized them. It is a lot easier to admit that investing in a stock was a mistake if you are not the person who made the mistake. Get a second opinion whenever you can.

Think about the silver lining.

It helps to think of your losing investments not as liabilities but as the tax assets they are. Taking a tax loss is one of the few attractive loopholes left for Canadians looking to reduce their tax bills. If you let your loss fester, it has no value to you. If, instead, you sell and lock in the loss, then you generate cash you can put to work elsewhere, and you can write off the loss and cut your tax bill.

Thinking about the tax benefits of selling your losers can help you stop focusing on whether the stock you sell might bounce back as soon as you sell it. As money manager Whitney Tilson of T2 Partners likes to say, “You don’t have to make it back the same way you lost it.” If a stock or fund was really a mistake, you should get rid of it and find a better use for the money. Murphy’s Law may rule our lives, but it doesn’t have to rule our portfolios.

One good reason to pay attention to these upstart economies is their sheer size. The four biggest of the emerging nations are Brazil, Russia, India and China, which are often referred to collectively as the BRIC countries. Just like a true brick, the BRIC countries pack a wallop. China and India are the world’s two most populous nations; Russia and Brazil also rank in the top 10, with populations many times that of Canada.

The BRIC countries are just the beginning of what’s available outside the developed world. The emerging markets category ranges from Poland to South Korea to Mexico to South Africa. Taken together, emerging markets now represent about a quarter of the global economy. Since 2001, their economic growth rate has been triple the growth rate of developed economies. Stock markets in these emerging market economies have churned out 21%-a-year gains over the past three years.

Strangely, though, Canadians don’t seem much impressed by this sizzling growth. Emerging market equities represent less than 1% of the money held in Canadian mutual funds. I fear that Canadians are simply not recognizing the new realities of the marketplace.

The most common objection I hear to investing in emerging markets is that these markets are too volatile. To some degree, I can sympathize with the complaint. Last summer, emerging market equities lost 25% of their value in less than two months. They subsequently regained all their losses, but their temporary plunge was scary.

The unfortunate reality is that you can expect more of the same. Emerging markets involve risk. Brazil and Mexico suffer from social imbalances and inefficient tax systems. Russia is moving back towards autocracy. India has to deal with inflation and a growing current account deficit. China is still a communist country where the rule of law is unpredictable.

But the problems don’t outweigh the potential. The key to investing in emerging markets is protecting yourself so you enjoy a high chance of profit and a low chance of losing your shirt. Here are four tips to help you on your way:

Think about the big picture

It’s reasonable to dedicate 15% to 20% of your portfolio to emerging markets. Don’t invest more unless you are a gambler.

No matter how much or how little you invest, make sure you diversify your holdings to ensure that a downturn in one region or country can’t sink your portfolio. In particular, you should avoid mutual funds that specialize in a single emerging market country or a small region. The risk is simply too high. A well-diversified emerging markets portfolio would have the bulk of its assets in the Asia-Pacific region (outside of Japan) with smaller portions invested in Latin America, Eastern Europe and Russia, and South Africa.

To hedge your bets, look at what else is in your portfolio. Emerging market funds usually move in ways that are out of step with Japanese equities, Canadian financial services or even Canadian balanced funds. If you mix your emerging markets investments with one or two funds from those other categories, you reduce your overall risk, since any downturn in one area is likely to be counterbalanced by gains in the other.

Go global

Choosing your own emerging market mutual fund can be tricky, since the funds available in Canada tend to be expensive and often go on hot or cold streaks that have little to do with management skill. As an alternative, consider investing in a global equity fund that has an emerging market component. The Trimark Global Endeavour Fund, the Chou Asia Fund and the Mawer World Investment Fund are all good examples.

Cut costs

If you decide to go all the way with a pure emerging equity fund, buy an exchange-traded fund (ETF) such as the MSCI Emerging Markets Index Fund, which trades on the American Stock Exchange (AMEX: EEM). This ETF gives you instant exposure to emerging markets around the world at much lower cost than an equivalent mutual fund.

It’s not just stocks

Consider emerging market bonds. A diversified portfolio of emerging market bonds is now yielding 2.5 percentage points more than a portfolio of Canadian bonds (or two percentage points more than U.S. bonds). With Canadian 10-year bonds currently offering a paltry 4% yield, this extra return is a welcome bonus for income-hungry investors.

The additional return isn’t without risk, of course. As Argentina demonstrated two years ago, governments in emerging countries sometimes default on their bonds. Still, if you keep a diversified mix of bonds, the risk premium should more than compensate you for any losses caused by default.

Before investing, you should be aware of a couple of specific pitfalls. The first is currency risk. You may take a hit if the currency the bond is issued in loses value against the Canadian dollar. This is true of any foreign investment and the best defence is a well-diversified portfolio that is split up among many different currencies.

You should also be aware that emerging market bonds fluctuate depending on how investors perceive their relative risk. The current two percentage point spread between emerging market bonds and U.S. government bonds is low by historical standards, suggesting to some observers that emerging market bonds are overvalued. Remember, though, that these are bonds, not stocks. If you (or your portfolio manager) hold on to your investment, you can enjoy the extra yield from these bonds and get back your principal upon maturity. The key is to invest only money that you will not need in the next few years.

To find a good emerging market bond fund, you will have to go outside of Canada and look at some of the ETFs available on the U.S. stock exchanges. You can examine the selection at a website called ETFconnect.com. Look for emerging market funds under the “Fixed Income” category. The site shows you the current annual interest payments and the degree of risk the fund is taking on. Risk is measured by the average credit rating of the portfolio. The holdings of emerging market bond funds typically range from relatively low risk BB+ bonds (one notch lower than investment grade) to high-risk C issues. You should look for a mix of high yield with relatively low risk. Right now, I think the Western Asset Emerging Markets Income Fund II, Inc. (NYSE: EDF) is appealing. It offers an 8% current income distribution level and has a BB+ average portfolio rating.

So where should you go looking for investment opportunities instead? In my opinion, small capitalization stocks — typically those of young companies or small firms — are the most tempting alternatives out there.

I’m not the first person to make the case for small caps, of course. Since 2001, small caps have delivered an average annual return that is north of 15% in Canada and 13.5% in the U.S. But while the prices for these stocks have soared, I believe there is still some value left, especially if you’re thinking in terms of a multi-year investment and if you know where to look.

I base my case upon history. Small caps have almost always delivered better returns over the long term than large cap stocks or bonds — and right now large cap stocks and bonds are so expensive that their returns are likely to be dismal for the foreseeable future.

James O’Shaughnessy, the well-known U.S. investment researcher and money manager, presents the evidence for smallcap stocks in his new book Predicting the Markets of Tomorrow. Using historical data, he concludes that the average real return (i.e., what you make after inflation) from an index such as the S&P 500 that focuses on large companies is just over 7%. But here’s the catch: if the actual return from these large cap stocks exceeds 7% for a sustained period, it tends to be lower in subsequent periods, thus reverting towards the historical 7% average.

O’Shaughnessy argues that since returns from the S&P 500 far exceeded the 7% historical average during the Internet bubble, we are now in a correction phase that will drag down returns to the range of 3% to 5% over the next several years. Once you factor in the 2%-plus cost of management on a typical mutual fund, you’re left with a dismal return that won’t do much to make your retirement dreams come true.

For bonds, the picture is even worse. With bond yields currently around 4% a year, you make next to nothing in real terms after you subtract inflation of 2% to 3% a year and investment costs.

The case for small cap stocks, fortunately, is much better. Smaller companies have more room to grow than big firms. They’re more nimble as well, so they can move faster than their bigger rivals to capitalize on opportunities.

History demonstrates the payoff from those advantages. Since 1925, small caps have outperformed large caps by two to three percentage points a year with only brief periods of underperformance. After crunching all the numbers, O’Shaughnessy expects small caps to return in the range of 7.6% to 9.6% a year over the next 20 years.

If he’s right, the implications are enormous. Investors who stick to traditional large caps, bonds and cash assets will need to work much harder for retirement. Those who venture more aggressively into the small cap world can reap significant long-term benefits, provided they choose their investments wisely.

The first step in choosing wisely is assessing just how much of a bargain you’re getting. Where the buys on the next page summarizes the current situation and, at first glance, it seems to contradict much of O’Shaughnessy’s advice. As you can see, large cap stocks look like a better deal at the moment than small caps. You pay a lower price-to-earnings ratio (P/E) to buy large caps. You also enjoy lower management expenses and trading costs — yet the bigger stocks are less risky than their smaller counterparts when you measure their beta, or how much they move up or down in relation to the market.

Fortunately, you see a more attractive picture if you look only at the value component of the small cap universe. These stocks are slightly cheaper and slightly less risky than the overall small cap universe. My conclusion? If you’re going to make a bet on small cap stocks, concentrate on the relatively cheap, relatively undervalued end of the category.

I am not — repeat, not — inviting you to put all your money in small cap value stocks and ignore everything else. Diversification remains the best long-term strategy. However, a moderate bias towards the small-cap value sector can let you benefit from the long-term potential of this category, while alleviating concerns about current valuations.

In Small game hunters below, I have compiled a list of funds that specialize in the small cap area and that have a decent long-term record and a value bias. My list is not based on any rigorous quantitative approach. I have simply selected a handful of small cap funds that I like, because I am familiar with their history and style. So much the better if some of those funds have sagged for the past year or so: I know they will come back, because they always have in the past.

Where the buys are

Small cap stocks are now more expensive than large cap stocks. But bargain hunters can still find a deal if they focus on small cap value stocks.

Source: data compiled from information available in the public domain on ishares.com for the benchmark index funds of each style.
Source of estimated trading costs for each style is Harry S. Marmer’s book Perspectives on Institutional Investment Management.

Small game hunters

A few of my favorite small cap funds. All my chosen funds favor value picks.