Risk and Green Investing

My father in law just sent me an excellent op-ed piece written by Peter L. Bernstein in the New York Times (Sunday June 22nd paper) that got me thinking about risk. I've talked a bit about risk in creating your portfolio, and I've beaten to death already the fact that I am risk averse, but I think given current market conditions, it's not a bad idea to rehash the concept.

First and foremost, it's important to define what risk is exactly. Despite there being hundreds, if not thousands, of measures of volatility, the article points out that the market tends to muddle the definitions of risk and volatility. In short, volatility is NOT risk. Risk is the likelihood that something will happen (anything, really). Volatility in financial markets is usually a reaction to the perception that something will happen (just about anything). When working to manage risk, it's a twofold process: 1.) you need to treat the symptom (volatility), and 2.) understand "the consequences of being wrong" [Bernstein].

So what does that mean for your portfolio, and what does that mean for green investing in general?

Step 1: Treating the Symptom

Hedge funds and portfolio managers big and small have a multitude of tools, one of the primary being the VIX, the CBOE index tracking implied volatility of the S&P 500 thirty days in the future. As the VIX rises, it indicates speculators percieve increasing volatility in the S&P 500's returns in the next 30 days (it's more complicated than that, but that's the gist - see this for more). Other favorites include the Consumer Confidence Index, and the easiest, plain old standard deviation. With all these tools at our disposal, it's still almost impossible to predict actual volatility. But at least there are easy ways to lower it.

To lower volatility, the simplest solution is to invest in less volatile assets. For instance, high volatility periods often see a movement from common stock to bonds as people get nervous. This can tend to inflate bond prices in the short term, but volatility in bonds tends to be lower than in common stock, so the concept works. It's important to note that your return may suffer, but that often is the cost of fear. In the world of green investing, this would mean moving from something with high volatility (and often a chance at higher returns) like Renewable Energy (like this for example) to lower volatility investments like Socially Responsible Bonds (like this for example). What's better than removing volatility? Removing volatility without sacraficing returns. That's what non correlated diversification is meant to do, and why it's the cornerstone to modern portfolio theory - invest in multiple non correlated asset types to increase returns and lower volatility. For green investing, we've made it simple and done the work for you (if you want more detail, don't hesitate to give us an email or call, or keep reading as it comes out).

Step 2: Understand the Consequences

Understanding the consequence of an investment is absolutely necessary for any informed investor. At the risk of proselytizing, informed investing can mean the difference of thousands, if not tens or hundreds of thousands, of dollars. Most retail and institutional investors don't have the time, expertise, or desire to fully research their investments. This is why investment professionals exist. And even though I think most investment professionals are concerned with their own bottom lines, I believe that the free exchange of information is absolutely necessary in understanding the consequences of an investment. In ther end, a well informed decision is the key to any strong investment portfolio, as well as risk management. To that end, unless you manage your own portfolio, find someone you can trust. I said it before in my Beginner's Guide to Green Investing, but investment professionals are there for a reason (myself included).

The second part falls on you: decide how much risk you are willing to take, and what consequences you can live with. My former mentor said it best: "Why take more risk than you need to get where you're going?" It's an excellent philosophy in general, and it gets to the heart of the issue: your comfort level. The best risk management is not to take any more risk than you can afford, or if you do, never go outside your comfort zone.

Green Investing and Risk Management

In many ways, Mr. Bernstein makes a compelling argument for green and social investing. I believe green investing and socially responsible investing fundamentally address mitigating risk by understanding the consequence of investment. I'm not one to trust what I'm told even with responsible investments, but investing in a sustainable way in responsible companies avoids many foreseeable consequences like subprime meltdowns or Enron debacles. That green and socially responsible investments often have some measure at least of social risk management built in works in its favor.

In practical terms, a simple socially responsible screen (the standards are tobacco and firearms screens) avoids some measure of litigation risk, as these industries tend to be highly litigious in nature. Litigation leeches profits and creates unnecessary strain on cash flows. It can also lead to unethical behavior internally or public outcry externally, both of which generally have negative consequences in the long term. Green investments often employ more stringent corporate standards (the "reap what you sow" effect), but even the very nature of their products tend to err on the responsibility. Environmental consequences are often intangible and difficult to ascribe values, however the writers at Environmental Economics do an awesome job at breaking it down. The truth is, change to environmental policy in this country has taken so long in part due to our indifference when there is no clear pricetag attached. Even if the negative consequence avoided is somewhat intangible, it is still avoided just the same. That said, there are a number of risks avoided when comparing non renewable energy to renewable energy. For instance, coal plants are forced to comply with government regulations for pollution output (though enforcement has been virtually non existent for the better part of this decade). This places a burden on the coal companies to either pay fines or install equipment, both of which come at cost to the investors in the long run. A wind turbine farm, on the other hand, faces far fewer regulation due to its exponentially less pollutants, and can profit where coal can't.

Whereas Step 2 is in many ways built in for green investors, Step 1 (volatility) is most definitely not. This is where investment professionals can be most helpful, but as a good starting point, see our last piece on asset allocation within green investing. And watch out for more as we continue with the Smug take on reducing green volatility.

For those of you looking for more personalized help, please feel free to email or call us. The advice is free, and I welcome the conversation. So be green and invest Smug!