Everyone has social issues they care about. And for a lot of us, we want to make sure our investment portfolio reflects our beliefs.
But there’s a tradeoff. Anytime you design your portfolio around something other than the specific dimensions of risk with higher expected returns, you are making your portfolio—to some degree at least—less efficient.
For some folks, that’s fine. They are happy receiving lower expected returns if that means they can avoid the companies they don’t want to be associated with.
But it’s important to recognize what you’re doing.
In this two-part series on socially responsible investing (SRI), we’re going to look at the motivations for using an SRI approach (today), and some things to think about when you are implementing an SRI portfolio (in part 2).
There are two main motivations behind socially responsible investing:
- To hurt the companies you don’t like, and
- To avoid associating with companies you don’t like.
Making Bad Companies Pay
This first reason—to hurt the bad companies—doesn’t work. The idea behind it makes enough sense: if a large enough group of people actively avoid buying a company’s stock, it will cause the price to go down and hurt the company—including making it more expensive for them to raise money.
Conceptually, this could work. But it would require a very significant portion of the market participants to avoid a company. Frankly, most investors—especially the large institutional players—are amoral.
They don’t worry too much about the morality of the business, unless it might bring on future regulation or otherwise hurt the economics of the business. If they think a stock is undervalued, they will jump in and buy up as much as they can—regardless of the company—which will drive the price up.
To date, there really isn’t any evidence that SRI has significantly affected a stock’s price. And in fact, there are some mutual funds specifically devoted to investing in “bad” companies (for example, VICEX) to try to harvest the effects of people avoiding certain companies or sectors.
As a result, the stock prices of “bad” companies are still based on their economic prospects—and the morality of their business practices impacts their price only so far as it impacts their actual business.
Keeping Your Hands Clean
The second reason for socially responsible investing—avoiding the bad companies—makes a whole lot more sense. While you may not be able to punish the bad companies, you can essentially sidestep them. As I said before, there is a cost to this, but it’s one that a lot of people are willing to pay.
The cost comes in the form of reduced diversification. If the companies that you wanted to avoid were sprinkled randomly throughout the economy, the cost wouldn’t be particularly high. You would have fewer companies in your portfolio, but it would be manageable since you wouldn’t really be changing the “look and feel” of the portfolio.
The problem is, they aren’t evenly distributed throughout the economy. People interested in SRI oftentimes don’t just want to avoid specific companies, they want to steer clear of entire industries. For example, you don’t just want to avoid ExxonMobil, you want to avoid the entire oil industry.
Because the companies you want to avoid are generally clustered together, you are systematically excluding whole chunks of the market (which is pretty much the point of most people doing this). As a result, your portfolio is not fully diversified, and you are leaving more of the risks you don’t get paid for floating around in your portfolio.
But if it helps you stay invested (or just be invested in the first place), then that’s the only thing that matters. Disciplined investing is difficult, so if SRI keeps you disciplined, then it’s worth considering.
The markets reward investors who stick it out over the long term. There are no guarantees in finance, but the odds of having a successful investment experience increase the longer you are able to stay in the market. And anything that helps you stay focused on (even imperfectly) capturing market returns is something worth considering.
That being said, if you are interested in pursuing an SRI strategy, there are a couple of things that you will need to pay attention to: your SRI strategy and the implementation of that strategy. We’ll cover both of those areas in part two.
Want to talk about incorporating SRI in your strategy? Contact us today.
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