Steer clear of China's stock market

While there are many opportunities China, a country of some 1.4 billion people, an average investor hoping to cash in by investing directly would be entering a minefield. China’s primary stock market has been running for 25 years and has seen 27 bear markets.

Beijing recently became the first city to be awarded both the Summer and Winter Olympics — despite the fact that the mountains that will host winter events 90 miles from the capital provide little in the way of snow, or even water. The solution: China’s government will make, store and distribute immense amounts of artificial snow.

Investors tempted to venture into China should consider this news, because it neatly symbolizes the craziness of China’s markets. Most of the shares are controlled and often manipulated by the government, so normal laws of supply, demand and common sense are often nonexistent.

Recently the government tried many unconventional methods to try to halt a market crash. It outlawed the selling of stock by large shareholders, stopped trading of certain companies for months and threatened to arrest those who violated any of its numerous restrictions. It is highly doubtful such policies will work over the long run.

While there are many opportunities in this country of some 1.4 billion people, an average investor hoping to cash in by investing directly would be entering a minefield. China’s primary stock market has been running for 25 years and has seen 27 bear markets! (A bear market is defined as a market loss of 20% or more.) China has also seen gains of 100% during this time period — eight times, in fact. This kind of volatility is simply too great for average investors. Such people tend to buy when times are good and sell when things reverse course. Doing this in China would be market-timing on steroids. The losses from the large swings could be horrific.

In contrast, over the past 16 years, the U.S. has experienced two very bad bear markets. Investors who consider the U.S. markets “risky” probably have no business allocating their funds to China. Sure, some pretty crazy stuff can happen in the domestic market, but it pales in comparison to the shenanigans that go on in China. In 1992, for example, Chinese investors literally rioted over suspicions that Chinese government officials were hoarding soaring IPO shares for themselves.

The fact remains that the Chinese markets are a mystery to those not deeply familiar with the intricacies and nuances of Chinese culture. Legendary investor Peter Lynch once said, “Know what you own and why you own it.” This timeless quote should make you very wary about casting your hard-earned money into the turbulent sea of Chinese stocks, where corruption remains a problem, market disruptions are often blamed reflexively on foreigners, the government changes rules on a whim and unsophisticated retail investors wager cash on equities like roulette positions in a casino. All of which lead to violent swings in both directions.

That’s not to say you shouldn’t have any exposure to China. The combined market capitalization of all its exchanges is about $8.4 trillion, second only to the United States. One way to gain some access is to purchase a low-cost total international index fund from a provider like Vanguard or iShares.

A common rule of thumb is to have 20% to 40% of your stock allocation in foreign markets, although many investors have nowhere near this amount due to “home country bias” — a preference for investing in your own domestic markets. If you have a standard portfolio made up of about 60% stocks and you allocate 30% of that overseas, your international exposure would be 18% (0.30 x 0.60 = 0.18). The aforementioned international funds allocate about 5% to the Chinese market. That means your overall portfolio would have about 1% allocated to China — and that 1% would be diversified within that country’s stocks.

For most people, this is the way to go. Warren Buffett once said, “Never invest in a business you cannot understand.” Your portfolio can be adequately diversified without venturing unaided into markets that are very difficult to comprehend and that ignore basic rules of economics.

Sensible low-cost diversification can lower your risk and increase your return. But there is a term in investing called “diworsification.” This is the idea that spreading your money into everything can actually lower your returns and increase your risk. Diving into China’s immature investment markets is inviting the latter.

This post first appeared on Nasdaq.

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