Diversification has been the most touted portfolio strategy for as long as I can remember. Buying into index funds representing thousands of companies across all sectors has, indeed, proven a solid bet. Index fund holders often own a portion of the economy, and the economy during our lifetimes has generally done very, very well.
But what if the economy didn’t do well? The S&P 500 has grown at an inflation-adjusted 7% since 1957. This growth has been largely dependent on both the explosion of human population and on the increasingly scary efficiency with which we’re able to transform the Earth’s resources (animals, minerals, forests) into things that grow our economies. Malthus predicted that eventually we’d run out of resources, and at the rate we’re going he may soon be proven right. Infinite growth isn’t possible, and 7% inflation-adjusted return on capital certainly isn’t possible if the world is at war because we have nothing to eat. Under a really rosy scenario, assume we all sacrifice and make a really good faith effort to turn the ship, which causes a bunch of investments to get stuck in then-obsolete industries (oil, coal, gas). The S&P, in this optimistic example, could lose 25% or more of its value even as new growth opportunities are taking foot. Under all scenarios, consider what happens when a bunch of the companies in your index funds own significant assets in areas under risk of wildfire, intense storm, or floods. Or, what if those companies owned farmland in increasingly drought-prone areas? Most ominous, what if the profits of these companies depend on consumers who live in areas at risk of climate-related devastation? It’s easy to envision significant losses in the most benign of scenarios. Catastrophic losses are more likely.
Setting yourself up for the clime ahead means investing in things that will retain or increase value. While we can’t know climate change’s effects specifically, we can make some general guesses that may allow targeting investments in companies with assets or consumer bases in particularly well-positioned industries or regions. This practice is bound to increase as additional data becomes available and firms are better able to analyze and estimate impacts.
As an example of how this might happen, in April 2019 S&P Down Jones launched a new Index that benchmarks the S&P 500 while excluding companies that don’t meet a variety of Environmental, Social, and Governance (ESG) investment criteria. It basically removes fossil energy firms, some weapons manufacturers, and other comic book villains bent on global destruction. Let’s say there was something similar that excluded firms failing to hit particular marks on a climate resilience scorecard. To be clear, I’m not talking about reductions in carbon emissions or chemicals usage, or fair wages—I’m only referring to excluding companies that are invested in or reliant on high climate risk areas. A company putting 25% of its capital into Miami beachfront real estate, for example, would probably get excluded from my imagined index.
In the absence of any similar investment vehicle, we’ll have to do this work for ourselves. Alternatively, maybe I should start an ETF? Its ticker will be CLME, of course.
As we know, turning the ship is a time-consuming effort; the bigger the ship, the slower is turns. But despite its size, we can all make the effort to get it to turn. Helpful analysis of economic diversification, and how it may assist us in getting the ship turned.
Hmm, the S&P 500 ESG Index you mention in fact DOES include energy firms, such as Exxon Mobil.
Not sure how to add a link, but look at this and view the ‘constituents’:
https://us.spindices.com/indices/equity/sp-500-esg-index-usd
So I guess oil and gas are not yet perceived as negatively as cigarettes! We need to keep working on this.
What would your climate resilience score look like? Flood risk, fossil fuel avoidance, what else? Interested in your thoughts on this subject.
You’re on the right track. Spitballing, I imagine it considering direct climate risks (E.g., floods, wildfires) on property, plant and equipment, along with factors such as the resilience of the area (infrastructure, society factors), critical supply chains (fossil fuel reliance), and resilience of end consumers and distribution channels. Apply it to the S&P wouldn’t be an easy lift, but it’s doable. Thanks for prompting the thought, and for hugging trees!