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December 29, 2011 / schoolthought

Socially Conscious Investing

I first heard about socially conscious investing a couple of years ago. This style of investing is a new practice whereby people only invest in firms that meet a certain level of ethical criteria. This usually means not investing in firms that produce guns, tobacco, alcohol, casinos, firms that heavily pollute, and so on. Many wealth managers and other investment firms now offer socially conscious investing as a service to meet the demand of such investors. My theory is that, although socially conscious investors may believe otherwise, this style of investment will have no effect on the bottom-line of any of these ‘unethical’ firms.

Firms make money by selling their service or product. They typically raise debt and equity to finance their operations and expansions. Once a firm goes public this debt and equity is sold on a secondary market, such as a major exchange. In its simplest form a share of a company derives its price from fundamental analysis (the current price of the firm plus future cash flows) and supply and demand for the stock. Now, let us assume the firm Death Inc. has issued public equity and that each share is worth $50. Death Inc. share prices haven’t substantially changed in three years as it is a stable company with little growth that pays a consistent dividend. This is common for these types of firms. The shares of Death Inc. are valued based on the firm’s present value and future earnings potential. If Death Inc. wants to raise equity and issues more stock, it will be able to issue shares at the current price of $50.

Now assume that socially conscious investing just became popular. Many people suddenly realize that their financial advisers are investing their money in Death Inc. They request to have the shares immediately sold and reinvested into more ‘ethical’ firms, driving down the price of the company’s shares. Now Death Inc. has shares worth $48 even though none of its fundamentals have changed. At this point Death Inc. and its shareholders are clearly worse off. Now if the company wants to issue more equity they will be forced to sell it at $48 a share rather than the previous $50 a share. This will make issuing equity more expensive for Death Inc. But luckily for the firm this disequilibrium won’t last long. Other investors who are willing to invest in Death Inc. without ethical qualms will realize that the fundamentals of the firm haven’t changed but the stock is suddenly worth less. So they will now buy it up back to $50 a share.

This works out to a transfer of wealth from socially conscious investors to all other investors. While this happens the price of a share of Death Inc. essentially remains the same. If this theory holds then the bottom line of Death Inc. will not be affected by the decisions of socially conscious investors. The only difference is that the socially conscious investors have made the purchase of  Death Inc. shares more attractive to all other investors. Markets are typically very efficient, and unless everyone works together to withdraw financing from ‘unethical’ firms, those who don’t care will arbitrage their share price back up to where it was before socially conscious investors withdrew their capital. This process ultimately renders socially conscious investing useless from a consequentialist standpoint (that is, a philosophy that focuses only on the end rather than the means). While some people might still sleep better at night without Death Inc. in their personal portfolio, nothing about the firm will have changed for their having not invested.

The only true difference will come if socially conscious investing reduces demand for the products and services of Death Inc., which doesn’t seem to be the case. Without a coordinated effort by investors, which also seems unlikely, Death Inc. will continue to received adequate financing at the equilibrium price. Meanwhile, money managers and financial advisers will make easy management fees from catering to those who demand special ‘socially conscious’ plans, and the rest of the market will make money by arbitraging the equity shares of ‘unethical firms’ back to their equilibrium prices.



Leave a Comment
  1. Anonymous / Jan 4 2012 12:56 am

    youve only really touched the surface here, and really this example has less to do with socially conscious anything than just market forces in balancing under constant demand. and honestly, the whole point of socially responsible investments is that it us supposed to decrease your demand for death inc while increasing your demand in the socially conscious product, which depending on your assumptions may or may not be entirely different. i’m not convinced there’s arbitrage there. in your scenario, it’s almost as if it’s just the entry of a new competitor.

  2. schoolthought / Jul 12 2012 10:19 pm

    Thanks brother!


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