Investing for the future can be confusing for many because of how many variables are involved.
There are many things to take into consideration when choosing an investment. Costs, performance, security selection etc.
Today you’ll learn about one of the most important investment considerations that is frequently overlooked.
ESG Investing, what's fear got to do with it?
I’ve been a financial planner since 2007 and one of my biggest ah ha moments was when I realized that financial questions do not need financial answers.
Financial questions are best answered in three different ways.
If you’d like to learn more about this, read here.
Let’s start by framing this up a bit.
I’m writing this in April of 2020. The middle of the Covid 19 pandemic. This is the sharpest and quickest decline the stock market has ever seen.
I have received countless emails and calls from clients.
“I’m starting to get panicky”
“I’m getting freaked out”
Do you think that these clients will be best calmed by spewing data about historic interest rates, max drawdown statistics or stimulus package details?
According to the Vanguard Advisors Alpha study,1 one of the largest benefits a financial planner can provide is through behavioral coaching. IE, guiding you instill good behaviors and helping you manage your emotions when the investing road is rough.
There is more value in talking you off of a ledge than in talking you into buying xyz stock.
So how does this relate to ESG investing?
Let’s look at two factors.
The Return Gap
“Firms Of Endearment”
1) The Return Gap
When you look at the return history of a particular investment, there is generally a difference between the investments stated return over a given time period and the actual return of the investor received.
For example, XYZ fund returned 10% over the last X years. You would think if you had been invested in that same fund, you would also have a 10% return. In reality though, the typical investors average return will be less than the funds 10% stated return.
This is due to a number of factors. Trade fees, commissions, account fees, dividend reinvestment etc. But for now we’ll focus on one aspect, investor behavior.
Check out the visual below.
You’ll see the range of emotions involved in a typical market cycle.
If emotions are not properly managed during volatile markets, poor decisions can be made.
These poor decisions (selling out or changing investments) contribute to your Return Gap.
Anecdotally, I started in this industry in late 2007. Probably the worst timing possible.
When the market was at it’s worst, I had a handful of clients ignore my advice and sell out of their investments. Do you know when most of them sold out?
March of 2009
Right at the bottom of the worst stock market decline most of us will (hopefully) see in our lifetimes. And right before the longest bull market in history.
Their return gap is HUGE!
A study by Derek Horstmeyer, Assistant Professor at George Mason University concluded that the return gap is the smallest for index investors and sustainable investors.2
2) Firms of Endearment
Authors Rajendra Sisodia, Jagdish Sheth and David Wolfe wrote the book Firms of Endearment and provide breakthrough research about companies that profit from passion and purpose.
Companies not solely focused on shareholder profit alone, but exist for a higher meaning and responsibility of serving the interest of all stakeholders.
These are companies like 3M, Costco, Disney, Panera Bread, T. Rowe Price, Whole Foods.
Their research shows that firms of endearment outperformed the S&P 500 14:1 from 1998 - 2013.3
Performance aside, these types of companies tend to be innovators. They tend to have very loyal employees and customers. Employees who feel valued and customers who feel important will be better prepared to handle the economy's eventual downturns.
Where ESG Investments may have an advantage
Research shows that companies with higher ESG ratings (particularly higher governance ratings) tend to have lower earnings volatility.4
Consider companies like Volkswagen, Wells Fargo & Equifax who have all had major public scandals that greatly affected their stock price.
Many socially responsible investment funds did not include these companies in their portfolio. Not because these company’s financial data looked bad, but because their ESG data showed lower governance measurements.
Traditional financial analysis has a difficult time determining how exposed a company is for internal fraud.
While you can never entirely eliminate intentional deceit or corruption, analyzing a company with an ESG lens can provide a different picture when looking to make an investment.
Tying this back to your emotions
As humans, we feel the pain of a loss two times more than the joy of a gain.
Our emotions are at their highest when the markets are volatile. We are more likely to be like the investors I spoke about earlier who sold when the market was at it’s lowest.
That type of loss is incredibly difficult to recover from.
Not so much because of the loss of investment value, but more from the emotional effects it has on us over the long run.
Just imagine how much emotion is involved watching your investment dwindle down, (possibly) ignoring a professionals advice only to finally “go to cash” after your investments have dropped 20%, 30% or 40%.
What would you need to see, or have happen for you to feel comfortable investing in the stock market again? After all that panic and pain.
My guess is, probably a lot. As a result, you would probably not invest back into the market immediately. It would take a while.
If it happened at all.
This is the problem. Our emotions can get the best of us and override our logic.
This is where I believe ESG investing can provide you with more protection than a traditional investment.
Imagine that you’re invested into a portfolio of good companies. Companies who value their employees, their supply chain, their shareholders and everyone else involved.
Selling out of your investments during a market downturn would mean withdrawing support to these incredible companies.
Your decision to sell could create a ripple effect. This positive emotional tie to your investments may be enough to stop you from making a poor financial decision.
I believe that by looking at your investments through an emotional lens (when appropriate) can provide you with enough of a reason to stay invested when times are tough.
Your Values > Fear
If you're convinced that this may be a good idea for you, but don't know how to get started feel free to schedule a phone call. We're happy to help...
We're a different kind of financial firm than you may be used to.