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ESG Investing Doesn’t Make Sense – Except When It Does

We all pay for things that we care about. Whether it’s buying organic food, or buying American-made products, or donating money to organizations that we care about, we all choose to spend money that we don’t need to, so that we can do good in the world (or feel good about ourselves, depending on how cynical you are feeling right now). I’ve been thinking about how we are willing to pay for things with non-pecuniary benefits in the context of investing after we looked at dollar cost averaging – there’s a cost, but it can make your life better in the long run (and in the right circumstances). ESG investing also fits this bill. But before we dive in on that, let’s make sure that we are on the same page.

What is ESG Investing

ESG investing is any investment strategy that incorporates Environmental, Social, or Governance concerns when deciding how to allocate it’s investments.

Essentially, with ESG investing, you’re choosing to alter your portfolio based on ethical considerations.

You’re either avoiding buying the companies you’re uncomfortable with, or actively trying to buy the companies that are doing good things. Either way, you’re making a conscious choice to move away from the market based on something other than the risk factors that have positive expected returns. These approaches, almost invariably, lead to some limits on the diversification of your portfolio.

Diversification is a Good Thing

Now, we know that diversification is the only free lunch in finance, and with ESG investing, we’re actively choosing to limit what the portfolio can buy: we’re deciding to make our portfolio less diversified. Put more directly, we’re choosing to accept a slightly lower expected total return and higher level of volatility to make sure that our portfolio is one that we are comfortable with from an ethical perspective.

Why Would You Do That?

Now, if we’re just looking at the numbers, there’s really no good reason to do this, but we aren’t Vulcans. There are non-financial theory reasons for why we would want to do things in our portfolios, as shocking as that might be. It’s perfectly reasonable to want to avoid owning certain companies – or to want to overweight other companies – even if you are potentially reducing you investment returns.

The reason for this comes down to discipline. If your portfolio doesn’t line up with your beliefs, you’re likely not very comfortable with your portfolio.

If you aren’t comfortable with your portfolio, then it’s going to be a lot harder for you to stick it out when the markets get “choppy,” especially if that choppiness all seems to be heading down. This is ESG investing comes into the picture for a lot of people. The whole idea behind ESG investing is to create a portfolio that you can feel good about, and one effect of that is making it easier to stay disciplined during the tough times the market will send our way.

Why Shouldn’t You Do That?

Like anything else, there are also a some really bad reasons that people put forward for using ESG investing.

One of the most prominent of these bad reasons is that you want to either raise the cost of capital for the companies that you don’t like or lower the cost of capital for the companies that you do like. The idea here is that your investment choices (along with other like-minded investors) will either make it easier or harder for a company to raise money, which will in turn either help or hurt the business.

Now, the thing is, there’s actually a tiny bit of merit to this argument (which is why it gets made so often), but the result is really too small to have a measurable effect.

Let’s take a look at the exclusionary side of the board, where you avoid buying shares of companies that you disagree with. If everyone agreed with you and refused to own a particular company’s shares, it would absolutely raise the cost of capital for the company significantly.

Unfortunately, that’s not what’s happening.

Not Everyone Agrees

We don’t have that critical mass of investors who are choosing to exclude companies from their portfolio based on the same set of ethical concerns, and even among the folks who do want to exclude the bad companies, not everyone agrees on who the bad guys actually are.

The tiny bit of merit to these cost of capital arguments comes from the fact that economics happens at the margins. Your individual choices do have an impact on the entire system, however small that happens to be.

Your choice to abstain from buying shares of certain companies (that you would have bought otherwise) means that there will be very slightly less demand for the stock than there would have been otherwise. This means that, theoretically, the share price of that company will be lower, and the cost of capital (and expected return of the stock) will be slightly higher, but… the effect is miniscule. It doesn’t have a meaningful impact on the company’s cost of capital, or on it’s operations.

The Financial Markets Are Huge

The problem with this cost of capital story is simply that the market is absolutely massive, and most people invest amorally.

If I exclude a stock from my portfolio, and ever so slightly increase it’s cost of capital, well, there’s another investor right behind me that will see that ever so slightly higher expected return and be more inclined to buy the stock. It’s the opposite story for the ESG funds that overweight the good companies; to the extent that my extra investment in a company reduces it’s cost of capital (and reduces it’s expected return), then other investors are going to be slightly less inclined to buy it.

Should You Use ESG Funds?

The reason to use socially responsible investing isn’t to help or hurt specific companies, or industries, it’s to make yourself feel more comfortable with your portfolio. It’s to either be part of something that is meaningful to you, or to avoid being a part of something that you dislike. Because remember what a stock actually is – it’s an ownership stock in a company. When you own a share of a company you are a part owner of that company, however miniscule your ownership stake might happen to be. And for a lot of people, there’s a lot of meaning wrapped up in that.

There’s a cost to socially responsible investing, but to the extent that it can help you stay disciplined, it may actually help you have a better investing experience, and help you reach your goals.

Having a portfolio that you believe in, and that you will stick with when the markets aren’t cooperating is a lot more useful than a finely tuned portfolio that will eat at you and make it harder to stay the course.

And if the portfolio that feels right to you is a portfolio built around ESG investing, that’s great.

To find out more about how to build an investment portfolio that works for you, read our eBook 9 Principles of Intelligent Investors.

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