What Goes Up Doesn’t Always Go Up
The latest disaster in the financial markets has once again shown that some of the biggest risks investors face derive from the excesses of free markets themselves. This time it was unregulated lending, leverage and speculation. In 2000 it was over-optimistic and at times corrupt Wall Street analysts, gobbling up creative corporate accounting that massaged income statements to show profits where there were none.
Some of the other systemic risks embedded in financial markets are barely on the radar screen of most investors. These range from unregulated pollution causing global warming, to the worrisome increase in nuclear proliferation during the Bush years. Preventable increases in sea levels might warrant more investor attention than, say, which large-cap growth manager should be hired or fired. There might not have been a worse piece of news for long-term investors over the last decade than Pakistan’s A.Q. Khan passing on nuclear secrets to other countries, yet there is no widespread investor effort to reduce the nuclear threat.
Why don’t investors pay more attention to these massive risks, and try to do more to reduce them? The answer lies in an almost totemic belief that markets go up in the long run. In fact, financial asset values don’t inevitably rise, even over twenty and thirty year periods. Market outcomes are conditioned by the public and private governance systems in which they operate. By influencing these governance systems, investors working together can reduce market risk and positively influence long-term market outcomes. To do so, however, will require accepting that markets do not magically inflate, and that investor passivity is in fact a very risky strategy.
Some large institutional investors are starting to wake up to the latent risks in the system and their role in mitigating them. Investors responsible for over $15 trillion in assets have signed on to the UN Principles for Responsible Investment, which state that ‘environmental, social, and corporate governance (ESG) issues can affect the performance of investment portfolios.” Investors with over $7 trillion in assets (including Trillium Asset Management Corporation) have joined the Investor Network on Climate Risk (INCR), which has been pushing for more analysis and disclosure of the potential impact of climate change on corporate performance. Capitalizing on the regime change in Washington, INCR’s members are advocating strongly for improved public policy to ensure global emissions reductions.
It is an enduring irony, last learned during the troubles of the 1930s and 1960s, that no group has a greater self-interest in vigorous public governance than the investor class. The door has opened for substantial public policy reform not only in the financial sector, but also on other critical issues affecting long-term investor outcomes. These range from energy and the environment, to health care, income distribution, and global security. With the widespread use of mutual funds and other diversifying strategies, virtually all investors large and small have a stake in eliminating environmental, social and governance failures in the service of their long-term portfolio returns. Investors of the world, unite!.