Like many investors, market volatility shook me into a silly stupor these past few years. Rather than taking advantage of price dips, all too frequently I just sat on the sidelines and watched my portfolio whipsaw.
Most African stock markets, as we saw last week, were every bit as volatile as US markets during the past five years. In fact, most were downright capricious.
Take a look at this five-year chart to get a sense of just how seasick Nigerian investors must feel. In the month of January 2009, the MSCI Nigeria Index plunged more than 41% in US Dollar terms. The next month it rebounded 26%. And then in March it swung 13% lower only to be followed by a 14% gain in April. Whew. I got nauseous just typing all that.
So why would anyone apart from an utter adrenaline junky even entertain the thought of investing in such markets?
The answer is diversification. Perhaps counter-intuitively, the more volatile assets that a portfolio contains the more stable it becomes. While some stocks zig, the others zag.
That’s one reason why fund managers like to invest in emerging market stocks. They tend to be less correlated with the S&P500, and, therefore, help smooth a portfolio’s performance. The less correlated a stock is to the overall portfolio, the greater its diversification benefit.
We measure correlation on a scale that ranges from -1.0 to 1.0. The closer the coefficient gets to either end of the spectrum, the stronger the correlation. A correlation coefficient of 0.9, for example, would indicate that two assets move nearly in lockstep with one another. A negative coefficient of -0.9, on the other hand, shows that the two assets react in almost opposite directions – when one drops, the other rises. Finally, a coefficient of 0.0 suggests the assets move completely independently of one another.
The chart below shows the correlation of monthly, currency-adjusted returns for a number of African indexes, the MSCI Emerging Market Index (EEM), and the S&P500 index since January 2007.
Note the strong correlation (0.83) between the S&P500 and the Emerging Market Index. The strength of the relationship shows just how interconnected global financial markets have become. It also suggests that adding emerging markets to a domestic stock portfolio provides a relatively limited diversification benefit.
South Africa’s Johannesburg Stock Exchange, with its 0.79 correlation to the S&P500, is a full-fledged emerging market. It is large and liquid, making it a favorite of fund managers desirous of exposure to the African growth story. The downside to this accessibility, however, is that it is likely to be hit first (and worst) when global markets take a tumble.
The next strongest correlation is between Kenya’s Nairobi Securities Exchange and its Ugandan counterpart. Investors from Kenya and Uganda can easily invest in one another’s markets. And landlocked Uganda is almost entirely dependent on trade routes through Kenya. Thus, Kenya’s 2008 political crisis hurt the Ugandan index more than it did the Kenyan stock market!
The markets of South African and Namibia also exhibit a strong relationship. The neighboring countries share a customs union, a currency linkage, and a lot of history. Thus their stock indexes tend to move in a concerted fashion.
Apart from those few relationships, however, African stock exchanges move together about as closely as do a herd of cats.
For example, the Nairobi Securities Exchange, one of the two largest African frontier markets, is essentially uncorrelated with its large West African counterpart, the Nigerian Stock Exchange.
Tanzania’s tiny Dar es Salaam Stock Exchange moves to the beat of its own drummer. Botswana’s stock exchange isn’t strongly correlated with any other market, and doesn’t appear to be at all correlated with East African stock indexes. Finally, the Lusaka Stock Exchange in mining-dependent Zambia is (perhaps surprisingly) not correlated with similarly mining-focused South Africa.
So, as you can see, a few well-chosen African stocks can go a very long way toward reducing a portfolio’s volatility. Who’d have thunk it? Apparently, the real adrenaline junkies are those that don’t invest in Africa.