Markets where only fools rush in

(Money Magazine) -- Whenever a popular investing argument starts to sound like a no-brainer, I know that lots of people will soon be losing lots of money.

Anyone with ears has been hearing lately how "it's obvious" that emerging markets stocks are sure to keep outperforming those in the industrialized world. To which I say, look out below.

Jason Zweig is the author of the forthcoming Your Money and Your Brain. E-mail him at investor@moneymail.com.

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Don't get me wrong. Investing in emerging markets is the right thing to do in the long run. But the investing gods punish people who do the right thing for the wrong reason.

Jump into emerging markets now in pursuit of hot returns and you're sure to get hurt. Here's why.

These days everybody from Goldman Sachs strategists to your dry cleaner seems to believe something like this: Because the economies of places like Brazil, China and India are expanding two to three times faster than in the U.S. or Europe, these emerging markets are bound to have higher stock returns.

But the obvious "truth" is wrong. The U.S. economy - the original "emerging market" - grew faster in the 19th century than in the 20th, and yet stock returns were no higher.

Over the past 20 years, Asia has grown faster than Latin America but Latin American stocks have done better.

And London Business School's Elroy Dimson, the world's leading expert on long-term market performance, has found that on average the highest stock returns come from the countries with the lowest rates of economic growth. In the long run, stocks in the slowest-growing nations earn an average annual return of 12%, or twice that of stocks in the fastest-growing economies.

Japan was the world's fastest-growing nation over the past century, but it produced the lousiest returns of any big stock market. The same upside-down relationship applies to countries such as Italy (high growth, low returns) and Australia (low growth, high returns).

What accounts for results that seem to fly in the face of basic logic?

First of all, when countries grow fast, the economic pie does expand, but it gets cut into thinner and thinner slices as more companies offer stock in initial public offerings.

In 2003, for instance, there was a single IPO in Russia taking in just $14 million. In the first five months of 2007 there have been 13 Russian IPOs raking in $16 billion.

Last year more than 130 Chinese companies issued roughly $60 billion in new shares. That's at least 20% more than the total value of IPO stock that was issued here in the U.S.

Future profits in China and Russia now have to be divided among many more investors. That leaves less for you.

Second, it doesn't matter how glorious the future turns out to be if you paid too much for your piece of it. Emerging markets stocks sell for an average of more than 16 times their net profits, while U.S. stocks trade at around 17 times earnings.

That gap is seldom so narrow, and when it is, emerging markets usually end up getting hammered. That's because they should be cheaper.

The U.S. government, whatever its faults, doesn't confiscate industries or create inflation so severe that you need a wheelbarrow full of money to pay for a loaf of bread. Russian president Vladimir Putin isn't shy about jailing critical CEOs and busting up their companies. The next stock he seizes may be one your fund owns.

I'm not saying you should bail out. As an enduring part of your portfolio, emerging markets are a great way to hedge against the hazard of keeping all your money at home; when the U.S. zigs, emerging markets tend to zag. If you invest patiently over time, you have little to worry about.

But there's a big difference between owning and buying. Owning an emerging markets fund permanently makes all the sense in the world. Buying one today - plunging in for the first time - does not.

Emerging markets will go on sale soon enough; the time to buy is when the headlines turn bleak and your friends stop bragging about how much money they've made in China.

When that day happens, buy a cheap index fund like Vanguard Emerging Markets Stock (VEIEX (Charts), iShares MSCI Emerging Markets (EEM (Charts) or Vanguard Emerging Markets (VWO (Charts).

Until then, if you want to jump into the developing world, book a vacation to Rio.

Asa Fitch contributed to this article.

Correction: An earlier version of this story listed VEMFX as the ticker symbol for the Vanguard Emerging Markets Stock fund. The correct symbol is VEIEX.