Thursday, May 15, 2008

Risk and reward

In yesterday's post I mentioned the possibility of greater risk arising from limiting your pool of investments. Basically, this is the idea that something along the lines of the S&P 500 contains a broad swath of the entire marketplace. If one sector does exceedingly well, another may at the same time be in trouble.

Holding a broad sampling of economic sectors in relative balance shields an investor from the risk that any one sector's decline will have too great an impact on their total portfolio. One of the consistent criticisms of SRI is that it tends to over-invest in "clean" sectors such as health care and technology, while under-investing in other sectors such as energy and defense. By doing so, are SRI investments inherently more unstable?

This is a contentious question. Henry Blodget, for instance, recently wrote about SRI in The Atlantic that "because companies and stocks that satisfy these criteria will likely be few and far between, you will have to live with the risks as well as the potential rewards of limiting your portfolio to a handful of stocks, instead of holding a diversified basket of hundreds."

Alicia Munnell, however, writing in Pension Fund Politics, states that "Screening securities could make it more difficult to achieve an efficient portfolio. But because an investor needs only twenty to thirty stocks to construct a fully diversified portfolio, the cost of a carefully screened portfolio is most likely zero. Eliminating tobacco stocks, for example, leaves enough securities to construct a market index; conversely, it is possible to put together an efficient portfolio from the full supply of socially responsible funds and companies. Overall, the results [of studies since the mid 1980s] show that the differences in risk-adjusted returns between the screened and unscreened portfolios are negligible and, in most cases, zero."

The Christian Science Monitor also profiled a number of recent studies on this subject here.

Thus, the academic weight seems to be on the side of SRI at least theoretically being able to avoid excessive risk. Nonetheless, it is still important to fully research any investment and to consider whether an SRI fund is too narrowly focused in one sector or too focused on emerging markets that may experience greater volatility.

Direct consumer risk through portfolios is only one part of the equation, though. In a later post, I will look at the possibility that SRI may help shield investors by reducing corporate risk through a change in practices.

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