Getting Serious About Long-Term Investing
April 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.
Other Posts in This Series:
- Social Finance from an Investor’s Perspective
- Allocate Your Risk Response: Ostrich, Musical Chairs, or Plan B?
- Investment Strategies: From Carpetbagging to Community
- Investment Strategies: Getting Down to Details on Eco-Carpetbagging, Global Good, and the Transition to Community
- No Time to Lose: A Call to Action for Impact Investors
- Published by Jillian McCoy
- Categories: Blog, Investing, Money
Really loved this article! Any discussion that questions our current assumptions with regard to risk models in long-term finance is a welcome refreshing change.
Comment by Cere Davis — May 4, 2010 @ 2:42 pm
Leslie!
Thank you for continuing to reenvision modern portfolio theory and for stimulating discussion around this vital topic for personal and societal action.
I am grateful for your work with RSF, Portfolio 21, Upstream 21 and the Local Economy Income Fund.
May you be blessed for working hard to take care of all of us and the planet with preventative financial medicine. I await your next post with baited breath. And I look forward to continuing with specific actions in my portfolio in response to what you are suggesting. Is there a name for portfolio theory beyond modern yet? And who coined modern anyway?
With globally warm regards, –Patrick
Comment by Patrick Malone — May 4, 2010 @ 3:24 pm
Leslie,
Bravo! I look forward to see the continued unfolding of your thinking. In particular, how do we as investors reconcile the assessment of financial risk at the portfolio level with the risk that the activities companies in our portfolios pursue (even the good ones) represent to the ecosphere?
best regards,
john
Comment by john fullerton — May 4, 2010 @ 5:13 pm
I welcome the discussion on limits to growth and the very real impact it should have on our lifestyle and investing decisions today. When we define the word “sustainability” we express a concern about future generations without acknowledging the inherent paradox of everyone around the world trying to live an lifestyle. The blunt question is whether we are willing to freeze (or shrink) our current standard of living to make room for others both now and in the future.
On the other hand, Leslie states that we crossed the tipping point on global resource use in the mid-1960s; I wonder how we prove that fact? The use of cradle to cradle thinking and sustainable technologies will enable us collectively to live much better on a global basis and that needs to be figured into the overall calculus.
Comment by Vince Siciliano — May 5, 2010 @ 5:11 pm
I was hoping for some suggestions on what to invest in. If one buys into the “limits to growth” argument, one would have to assume that commodities and energy will become more expensive as they are depleted. I hate to invest based on betting things will run out.
Comment by Stan S. — May 6, 2010 @ 4:33 am
Leslie,
Good for you for wading into the uncharted waters of what limits to growth will mean for investment strategy. Many others have talked about limits to growth, but no one to my knowledge looks at the practicalities of what this might mean for our assumptions about return on investment and the deeper implications that follow. Keep wading into those waters!
Fran
Comment by Fran Korten — May 11, 2010 @ 8:10 pm
The author writes:
” 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. ”
I’d be interested to know why it’s “financially intolerable” to posit no growth. Perhaps first one needs to agree on what growth is. Is growth defined to be a 4 or 5 percent increase in the GNP (or personal income or corporate cash flow) each year? Is perhaps this definition of growth at fault here rather than growth itself? My physical body hasn’t grown since I was 18 — may have shrunk a bit! — but I have been growing the whole time. Growth of a mature economy, like any mature organism, may not express itself in increase of physical consumption or size, but rather in reorganization of activities, increased differentiation of functions, improved social processes, well-being of citizens, etc.
Could it be that the real problem lurking behind the mainstream idea of economic growth is the growth of the money supply caused by the exponential growth of debt? This in turn can be laid at the foot of the idea of “interest on interest”, or “money makes money”. Isn’t this the real time bomb that makes it “scary” to contemplate no growth? However, the anxiety may be misplaced. Interest on interest has no correlation in a healthy living organism, the closest analogy, I think, is the spread of a cancerous tumor. No growth might mean no more tumor — the question is, can the patient survive?
I think the problem isn’t so much limited natural resources as how the pressure exerted by the debt bomb deforms the way in which the world economy uses those limited resources. The profligate cutting of rainforest timbers, indiscriminate drilling for oil, etc., etc., is done first and foremost to generate as much so-called profit in as short a time as possible, and cannot seriously be considered as a rational response to the crisis of limited resources. If we could direct our attention at the root cause — which I think lies in the way we have allowed money to take on a life of its own — then I expect that our perceptions of the limitation of our natural resources would look much less scary.
Comment by Charles Gunn — May 23, 2010 @ 12:10 pm