Are emerging markets the next bubble?

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005)

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NEW YORK (Money) -- Question: I'm considering investing in emerging markets mutual funds. But do you think that's a good idea, or are they just going to be the next investment bubble? -- Mario, Atlanta, Georgia

Answer: Last year, The Onion ran a hilarious"news" story about a panel of business leaders appearing before Congress to demand that "the government provide Americans with a new irresponsible and largely illusory economic bubble in which to invest."

The article was satire, of course. But what made it so funny was that it hit so close to the truth. It seems we just aren't comfortable unless we can pour our money into something that offers unsustainable returns.

And indeed, given how we've careened from one bubble to another over the past decade -- technology shares to Internet IPOs to residential and commercial real estate to mortgage-backed securities -- you can't help but wonder which investment we'll next infuse with unrealistic expectations that will eventually give way to bitter disappointment and big losses.

Will it be, as you suggest, emerging markets funds, which have already gained a bubblicious 69% for the year to date? Or how about high-yield bond funds? They're up an attention-grabbing 42% so far this year.

Or will old reliable gold step up again? It's already breached the$1,150-an-ounce mark this year and some gold bulls are saying there's no end in sight.

Truth is, though, while it's easy to identify bubbles after they burst, it's hard to know for sure whether you're in one while it's still inflating. You can suspect that returns may be too frothy. But there's always some rationale that not only justifies prices, but suggests why they've got a lot more room to run.

So I don't think it's possible to come up with a foolproof Bubble Detector. That said, I think there are three fairly simple defenses that should at least be able to limit the damage a bubble can do to you.

The first is common sense. Yes, I know it's gone out of vogue in an age where we're supposed to defer to pros in every aspect of our lives. But stepping back from the hurly burly of the investing scene and applying a little old-fashioned independent judgment can often provide a helpful bit of perspective.

Take emerging markets funds. They're up more than 120% since their November 2008 lows. That fact alone doesn't mean they can't gain even more. But you don't have to be an investing genius to know that this sort of sizzle will eventually fizzle. And if you look at the history of these funds, you'll see that they have a habit of generating colossal gains that are followed by huge setbacks.

But reversion to the mean applies not just to emerging markets funds. I'd say you should be wary any time an investment soars to truly outsize returns, especially if people begin piling into that investment like so many lemmings.

For example, seemingly unstoppable price increases triggered a feeding frenzy in housing earlier this decade, which prompted me to write a column warning people about loading up their IRAs with residential real estate. Did I know we were on the verge of a housing bust? No. But I knew that the combination of overheated prices and an insatiable appetite on the part of investors to throw even more money into the sector should make someone more wary than enthusiastic about jumping into real estate with the expectation of continued blockbuster gains.

The second defense is building a balanced portfolio. True, diversifying won't immunize you from bubbles. In fact, the more broadly diversified you are, the more likely you'll own an investment that goes into bubble mode.

But diversification does provide protection in that spreading your money among different types of investments rather than making a big bet on one investment you hope will deliver spectacular gains limits the potential for damage. Part of your portfolio might deflate, but not the whole thing.

So while I don't advocate investing in emerging markets funds because they've recently racked up impressive returns, one can make a case for owning them to diversify an already diversified portfolio even more.

Even then, I'd argue that you should consider flighty investments like emerging markets funds only if you're planning to own them for a long time, say at least 10 years. They're too volatile in my opinion for shorter holding periods. And I'd also recommend limiting your exposure. Highly volatile investments like emerging markets, high-yield bonds and gold are more like spices than main courses, so a little goes a long way. In the case of gold, you're talking maybe 5% to 10% of your overall holdings. In the case of emerging markets funds and high-yield bonds, it's probably more like 10% to 20% of your international and bond holdings respectively.

Your third tier of defense is rebalancing, or selling a portion of investments that have outperformed and plowing the proceeds into those that have lagged to bring your portfolio back to its correct proportions every year or so.

This technique prevents any single investment from becoming too big a part of your portfolio when it's on a roll. It also forces you to be a bit of a contrarian, selling off some of your emerging markets after a year during which they've had a big run-up and buying in after they've taken a beating. Put another way, it allows you to buy low and sell high, which is something investors know they should do, but too often lack the will to pull off.

So to answer your question, I think investing in emerging markets funds can be a good idea if you're doing it for the right reason (more diversification) and the right way (small portions that are part of a long-term asset allocation and rebalancing strategy). That said, I don't think anyone should feel compelled to add emerging markets funds to his or her portfolio. You can do perfectly well without them.

As for the bubble issue, I don't believe there's any way to know for sure if emerging markets funds are now in or will soon reach bubble status. But if money continues to flow into these funds mostly because investors are chasing past gains as opposed to building a better rounded portfolio, we could very well be headed toward another bubble, and, of course, a resounding pop!