Getting Serious About Long-Term Investing

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Apr 27 2010

By Leslie Christian

This is the second entry in a 6 part series by Leslie Christian on rewriting modern portfolio theory to recognize the reality of ecological limits to economic growth. To read Leslie’s other blog posts on the subject, use the links at the bottom of this post.

In the first essay of this series, I wrote about the need to reevaluate modern portfolio theory and asset allocation strategies in light of the undeniable reality of ecological limits and the impact this is having (and will continue to have) on our global economy. Today, I will discuss the risk of ignoring ecological limits and the implications for long-term investing, which will naturally lead us to questions of investment strategy and decision-making, to be discussed in future postings. As you read this post today, I ask that you remember that the foundation for making solid decisions is to consider, as fully and comprehensively as possible, all of the possibilities, including those that are frightening or seemingly implausible.

Ecological limits are real and non-negotiable. There is no “planet next door” where we can borrow clean air, fresh water, or arable land. While that may seem obvious, it is particularly important to consider given a milestone that was reached in the mid-1960s. We didn’t know it then, but as a global community, we human beings started spending our natural capital. Instead of living within our means on our natural resources and systems, we reached the tipping point where we were taking more resources out of the ground and putting more “stuff” into the atmosphere and landfills than our natural systems could support. We were officially in overshoot with all of the associated ramifications – global warming, climate disruption, deforestation, desertification, water shortages, etc. We know that we can’t indefinitely spend more financial capital than we are earning. Eventually, we would run out of money. Is planet Earth any different? Basically, no, except that we can exist without money, but we can’t exist without an ecosystem.

In the face of ecological limits, we must question whether we can reasonably expect our global economy to continue to grow as it has in the past. Unless we very rapidly figure out how to grow without using and emitting more “stuff,” we need to consider the possibility of an extended period of material economic contraction. To be blunt, this means no growth. This is the risk that no one talks about. It is politically unacceptable, financially intolerable, and downright scary to posit that we may not be able to grow ourselves out of our problems and into prosperity, out of debt and into surplus, out of poverty and into wealth. But refusing to acknowledge the possibility of zero or negative growth is to ignore a glaring risk. It is a breach of fiduciary duty for trustees, advisors, and consultants, and it is a huge planning gap for individual and institutional investors who depend upon positive financial returns to provide for critical future needs.

GDP growth is not an inherent “God-given” right, nor is it inevitable. And yet modern portfolio theory and associated asset allocation strategies fail to recognize this reality because they fail to explicitly integrate ecological limits into long-term analysis and projections. Perhaps modern portfolio theory isn’t so modern after all! A truly modern approach is to face up to the facts and deal with them.

But how do we deal with these facts? What will ecological limits look like? When will the economy start to really feel them? What does this really mean? Nobody knows. And this is, in fact, the definition of risk. We know that ecological limits exist; we just don’t know when or how they will manifest in every aspect of the economy. But that does not mean we should deny the risk.

So, what does this mean for investing? In a typical asset allocation model, provisions for temporary economic declines include hedging strategies such as elevated cash reserves, option-like investments, and defensive holdings. But these are short-term measures taken as part of a cyclical strategy. Surely, the possibility of long-term, continuous zero or negative GDP growth precipitated by ecological limits warrants deeper consideration for long-term investment portfolios. The asset classes that are typically arranged in a neat line representing the tradeoffs between risk and return (cash to bonds to public equities to private equity and venture capital, with real assets and commodities sprinkled in) do not tell a complete story, and to the extent that they embody the assumption of increasing economic growth, they are actually deceptive and misleading. We need to draw a new diagram, envision a different way of looking at risk and return, and redefine asset classes based on how well (or not) they mitigate and/or reward risk. We need to face the facts, and each of us as investors needs to make decisions about how to respond to the reality – and risks – of ecological limits and an economic system dependent on growth.

If you consider yourself a long-term investor, I encourage you to think about how you currently deal with (or would deal with) the possibility that we will not see average annual growth in our global economy. In the next essay, we will take a look at an alternative way to make asset allocation decisions.

Leslie E. Christian is Chief Investment Officer and Chief Executive Officer of Portfolio 21 Investments. She has more than 35 years of experience in the investment field, including nine years in New York as a Director with Salomon Brothers Inc. She received her bachelor’s degree from the University of Washington and her MBA in Finance from the University of California, Berkeley. Leslie is Chair of the Board of Upstream 21 Corporation and Portfolio 21 Investments and serves on the RSF Social Finance Investment Advisory Committee.

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