Behavioural Lessons from 2020

2020 has been a year to forget, but for investors there have been some lessons to remember:

Most predictions are pointless

As we finalise our predictions for 2021, it would be prudent to consider what our expectations were for 2020 and how those played out. Markets, economies and people are far too complex to foresee with any level of confidence or accuracy.  Making predictions about financial markets is one of those activities that we perform in an indefatigable fashion in the face of overwhelming evidence that it is a hopeless endeavour; perhaps because it is in none of our interests to state that we just don’t know. We should never make our investment outcomes reliant on heroic forecasts.

Making predictions is more difficult than we think

It is not simply that we did not predict a global pandemic that evidences our limited abilities in the art of divination; it is that even if we had known about coronavirus in advance, there is a very good chance we would have made some very poor and costly investment decisions.

Imagine if – at the close of 2019 – we were told that there would be a global pandemic in 2020 with an impact so severe most of the charts we use to track economic data would fall so precipitously that we wouldn’t be able to use them meaningfully in the future.  Would we have gone long global equities? Financial markets are complex, adaptive systems; even knowing certain pieces of information does not mean we can predict related outcomes. 

Recession and bear markets will happen

Although we cannot anticipate their shape or form, we should treat recessions and bear markets as an inevitable feature of investing.  Rather than worrying about when they will happen; we need to make sure we are appropriately prepared for when they do.   

Our tolerance for losses is behavioural as well as financial

Our capacity to withstand drawdowns and financial loss is often framed in purely financial terms – what is our ability to bear such risks?  Although this is crucial, equally important is our behavioural tolerance; are we able to withstand difficult periods without making poor decisions?  We need to understand how we will feel and how we might react. 

Bear markets are as much about how we feel, as how we think

Bear markets are a test of temperament, not intelligence.  Success through torrid periods is about having the disposition or processes that enable us to make clear-headed and rational decisions in the face of huge emotional stimulus.  If we don’t prepare then the chances are that we will be overwhelmed.

Investment intentions are not always easy to follow

The problem with investment intentions is that it is impossible to appreciate in the present how we will feel in the future when we actually have to implement the decision.  Saying that we will buy equities when they are 30% lower is easy to say and hard to do.   When they are 30% lower it will be for a reason, and there will inevitably be a host of negative narratives as to why they have fallen.  In the midst of that that noise, sticking to a plan is anything but straightforward. We should not make a decision about the future in a cold state and then try to carry it out in a hot one.

The best option is to make such choices systematic. This is why rebalancing is so effective – it systematises sensible decisions that we probably would not make consistently if left to our own capricious devices.

The next crisis will be different to the last

A host of behavioural factors – such as recency and availability – make us worry about yesterday’s crisis.  There will be misfortunes and turmoil in the future, but the causes will probably be different to the ones we are currently experiencing.  We should not let 2020 entirely define how we think about markets and future risks for the next decade. 

Market timing can be painful

The severity and speed of market movements in the first half of 2020 was a perfect example of the challenges and dangers of attempting to time short-term volatility. One wrong call during this period could have resulted in an arduous road back.

 In times of crisis, our time horizons contract

The most crucial discipline for the majority of investors is the adoption of a long-term approach when making decisions. The central problem of periods of crisis is that our time horizons contract dramatically. Our attention and concern is inexorably drawn to what is happening in the current moment. This risk of making reactive, emotion-laden judgements that make us feel better (and safer) in the present is never greater.

Events that feel seismic at the time will probably be a blip in the long-run

Events such as the pandemic feel profound for investors and it is hard to accept that they will probably appear to be an insignificance over the long-term (from a returns perspective).  Most things matter far less than investors think they will when we are living through them. 

The urge to action can be overwhelming.

The case for investors doing less has again been bolstered through a tumultuous 2020.  The impulse and encouragement to act during a period of such high volatility and extreme change was incredibly powerful. The hardest thing to do is the thing that nobody wants us to do. Sit on our hands, follow our processes.

We deal with risks which are current and salient

The political will to take such dramatic action to stem the spread of the virus provided a wonderful contrast with the trudging (in)action and apathy around the climate crisis.  The consequences of climate change for humanity are likely to be far more devastating, so why the indifference?  Coronavirus is present and salient; climate change is a future risk that feels removed and abstract.  The risk is stark that we don’t take enough action on the climate until its most severe implications are as close as the pandemics. Too late.

The outside view is easily ignored in periods of stress

In all our investment decisions we tend to focus on the issues specific to the particular case (the inside view) rather than general lessons or similar incidents (outside view).  When high yield spreads went to 1000 over in 2020, it was far easier to think about the disastrous consequences of the pandemic on default rates; than to focus on the historic attractions of investing at such widespread levels.  The outside view is even more important during tempestuous spells in financial markets. 

It is not the bear market that matters, but what we do during it

As investors we worry a great deal about drawdowns and losses. The potential damage wrought by bear markets and severe market losses always looms on the horizon, but we think about this risk in the wrong way. If we are appropriately diversified and have a long-term approach; it is not the short-term declines in markets that matter, but what we do in those periods. The consequences of rash behaviour and injudicious decisions made in difficult periods will likely have far greater long-run consequences than the near-term losses themselves.

It is difficult to think of a more challenging year to navigate for investors. The list of unprecedented events is long and distinguished. The potential to make classic behavioural mistakes driven by emotion, short-termism, and skewed risk perceptions never greater.  Yet the year is also testament to the benefits of being aware of our most damaging behavioural tendencies. 2020 was a behavioural stress test for investors. It is important to check how we fared.

10 (More) Questions ESG Investors Must Consider

The sheer pace of the move toward ESG and sustainable investment approaches means that it is often difficult to take time to reflect on some of the most pressing questions. I previously discussed 10 critical issues ESG investors must consider and, such is the scale and importance of the shift taking place, I now have ten more:

1) Does short-term performance validate the long-term prospects of investing in companies with strong ESG characteristics?

The answer is no. The relative performance of stocks with positive ESG credentials or those playing into the sustainability thematic through 2020 tells us nothing about the long-term return potential of such companies. Particularly dangerous are claims around their ability to prove resilient through a market downturn, which are often based on a sample of one.

Even longer-term suggestions about there being a return premium attached to ESG as a ‘factor’ cannot be disentangled from a decade of underperformance of value stocks, declining yields, and the corresponding outperformance of quality and growth.

Small samples, inconsistent definitions and post-hoc rationalisations are not a strong foundation to make claims about future returns.

2) Should high scoring ESG companies produce lower returns?

Amidst the strong performance and momentum of ESG investing, it is sometimes difficult to assess the landscape in a measured fashion. One important, but rarely posed, question is whether the best quality companies from an ESG perspective should produce lower returns for investors.  Although this sounds heretical in the current climate, the logic is simple.  From a financial perspective ESG investing is about how companies manage the environmental, social and governance risks that may impact their profitability and long-term viability. The companies that manage these risks well should enjoy a lower cost of capital, because the risk to their business is reduced (other things being equal).  Can we really have lower risks and higher returns?

This is admittedly an over-simplification. One could argue that high quality businesses have proven their ability to deliver strong returns for a prolonged period and mitigate a host of potentially material risks. Perhaps investors are still underpricing the ‘value’ inherent in such attributes. In a related fashion, it could be contended that the main mispricing investors are making is not applying a high enough cost of capital to poor actors from an ESG perspective.

Whatever your perspective, it is too simple to draw a straight line between ESG scores and future returns.

3) How do high scoring ESG companies or sustainable / thematic stocks generate excess returns?

Whilst we are not short of claims being made about the return potential of ESG, sustainable or impact investing; there is a lack of consideration about how such companies can deliver superior returns. There are several potential paths:

  • Momentum: Stocks in this sweet spot may continue to outperform simply because of the weight of money and price momentum in this area. Such trends can persist for far longer than fundamentals might suggest. 

  • Starting valuations: The price paid now may be sufficiently attractive to deliver outperformance through the cash flow yield provided by current valuation levels. 

  • Cost of capital reduction: A company might be re-priced based on a change in the return required by investors. This seems more likely to be the case when investing in companies that have poor / average ESG credentials now but are improving, rather than investing in those currently regarded as leaders.

  • Growth: The market might be underappreciating the long-term growth prospects of a business. This is probably the most common investment rationale in this area, particularly in the impact space.

If claims are being made about excess returns from an industry or specific company, it is important to be clear about how this is going to happen.

4) Are carbon intensity measurements a solution or a limitation?

There is no more important element in the movement towards ESG focused investing than the transition away from carbon and the need to slow the rise in global temperatures. A feature of this shift is the measurement of portfolio carbon intensity and often targeted reductions versus benchmark. Whilst this move should be generally applauded, this is an incredibly complex issue and one that is not fully captured by simple metrics alone. There is a danger that the desire of asset managers to ‘prove’ their ESG / carbon credentials means they focus simply on the numbers and measures that can be most easily produced, even if they may be of detriment to the overall goals.  What is measured is what matters.

Because of availability and clarity most carbon metrics encompass Scope 1 and Scope 2 data, this is limited because it misses the carbon emissions in the value chain. It is also important to acknowledge that reducing your portfolio’s carbon intensity on Scope 1 and 2 basis, does not alter the situation in and of itself – someone is still owning those emissions, just not you. This does not mean such behaviour is ineffective – the increasing attention on this aspect should encourage and incentivize all businesses to reduce their carbon intensity – but it is not the complete answer. We should not focus just on this element because Scope 3 data is messy and difficult.

There is nothing wrong with using Scope 1 and 2 data alone provided you are clear about what it is and is not telling you.  But the limitations of measurement here mean that it is dangerous to restrict and define yourself solely by a narrow and incomplete set of metrics. For example, if you set a restriction on the carbon intensity of your portfolio using Scope 1 and 2 data, you might prevent yourself from investing in transformational companies that are transitioning away from intensive carbon use because owning them is penal when making Scope 1 and 2 comparisons.

When an area is evolving rapidly the desire to measure and prove can be an impediment to progress rather than evidence that progress is occurring. It is important to be aware of what the numbers are telling us and how aligned they are with what we are trying to achieve.

5) What would be the impact of a prolonged period of value outperformance?

This is the great unknown. Although – despite recent events – it is difficult to envisage years of outperformance from value stocks*, it is important to consider whether such a scenario would dampen the enthusiasm for ESG investing. It seems almost certain that the movement has been accelerated by strong performance, but this is about more than return chasing. It is intertwined with a much needed realisation of the misalignment between the focus on short-term shareholder returns and the long-term needs of people and the planet. The shift would likely have happened anyway, but perhaps at a slower pace. 

The real challenge will arise when in favour ESG leaders begin to underperform – how will our behaviour alter?  It is crucial to acknowledge that our investment decisions around ESG and sustainability must encompass broader considerations than a purely financial return. There is a not inconceivable scenario where the transition towards ESG investing has dramatic benefits for the environment and society but produces underwhelming long-term returns in terms of narrow, relative investment performance of the funds focused on this area.

Aside from the potential non-financial benefits, the move towards ESG investing might also increase the long-run returns of most financial assets because of some of the major environmental and social risks it helps to obviate. This, however, is not an outcome we will notice when comparing the relative performance of our ESG-focused strategy to a benchmark.  This type of investing requires a broader lens when thinking of returns.  

6) How should investors be voting and engaging?

Another area where a desire to measure and provide evidence is running ahead of a clear set of principles is in voting and engagement. Being active rather than sedentary shareholders or lenders seems an unequivocal positive but when pro-active voting and engagement is encouraged it is sometimes unclear as to what outcomes should be targeted.

Let’s take a simple scenario. A major oil company is about to embark on a huge CAPEX program to move into renewable energy but given the amount of capital flowing into this area the returns on invested capital are likely to be exceptionally low. Significantly below that being generated in their existing business. Should a shareholder be supportive of this transition despite it likely being of detriment to their financial interests? There is no right answer here, but these are the sort of questions that need to be posed to understand what we mean when we talk about voting and engagement. Where do our priorities reside and what sort of sacrifices might we be willing to make?

7) Who should be defining what good ESG credentials are?

It is somewhat tired and trite to talk about the low correlation between different ESG ratings and scores, but the broader point is important.  Who should decide what ESG criteria are significant? Should it be asset managers, companies, ratings agencies or regulators? At some point judgements are being made about what is important and how important it is. The motives behind assessments will also differ markedly. An asset manager will likely be trained on how ESG issues will impact the success of a business (in particular the risks it might face), whereas a regulator will have a far broader perspective and be focused on the issues that most impact people and planet. These are not necessarily the same things.

8) How do we assess the trade-offs?

One of the most difficult elements of developing an ESG assessment framework is thinking about trade-offs. Judgements are persistently being made about the value (financial or otherwise) of one factor against another. How do we think about the green bond issued by a polluting but transforming utility company? How do we assess a company at the forefront of plastics recycling but with objectively weak governance? How do we compare the profound privacy, competition and societal issues stemming from big technology / media firms with the environmental impact of extractive resource companies? These are all incredibly difficult questions, and to suggest there are any easy answers is naïve or conceited.

9) What if all companies get better?

One consequence of ESG investing becoming ubiquitous is that we are likely to see an increase in overall ESG standards across most or all firms. The incentives for companies to address pertinent ESG issues is strong. If this occurs, then the ability to differentiate between good and bad actors will likely diminish, and distinctions will become increasingly marginal. This would represent a major success for ESG investing but will see it become much more difficult to apply. A positive endgame may even be that it becomes a redundant term because it is the norm. Not a problem for today.

10) Should a fund manager be able to say that they don’t do ESG?

Very few, if any, fund managers will say that they don’t incorporate ESG. Indeed, most will say that they have always been doing it, but just forgot to mention it. But is it a pre-requisite? Is it reasonable to say that they do not consider ESG factors? Yes and no.

All fundamental investors should analyse ESG factors to the extent that they believe that they will or could have a material impact on the operations of a business. To not do so would be remiss. It does not follow, however, that their portfolios should have positive relative ESG scores, or have any concerns wider than how these issues impact the returns made by the businesses in which they invest.

If a fund manager’s clear goal is to produce index outperformance and nothing else, it is perfectly reasonable (and implicitly expected) that they could ignore the best scoring ESG stocks if they believe they are expensive. They could also favour the ESG laggards if they believe that the ESG risks of the business are more than reflected in the valuation.

Incorporating ESG does not necessarily mean being long ESG leaders. If a fund manager is required to take more than pure financial returns into account, this should be made clear.

The dramatic pace of the shift to ESG investing belies many of the complexities and uncertainties that exist.  The tendency to suggest a strong relationship between ESG characteristics and future performance is a particular concern, both because there is not sufficient evidence to make such a claim and the unrealistic expectations it might set.  Furthermore, the desire of asset managers to prove their ESG credentials is leading them to use simple metrics to measure intricate and multi-faceted issues. The perils of Goodhart’s law mean that we need to be vigilant of the unintended consequences of such behaviour.  

The vital and wide-ranging objectives of ESG investing will be much better served by having open conversations about such issues and broadening the way we think about the returns and outcomes of ESG-focused investments.

*I am painting with an overly broad and short-term brush here – value stocks and ESG laggard companies are not synonymous; but as currently constituted the underperformance of value has been a tailwind for ESG leaders.