Climate Change Lessons for Your Portfolio

Most investors place a portion of their investments in high-cost, low-return fixed income vehicles to ensure at least a minimum of future wealth in case of the remote possibility of an equity portfolio disaster. Gernot Wagner and Martin L. Weitzman, authors of the new book Climate Shock: The Economic Consequences of a Hotter Planet, argue that the world should invest at high cost to ensure that humanity will at least survive, given the remote possibility of climate catastrophe. They also say, however, that investing in geoengineering as insurance against climate change may be like purchasing an annuity from the devil; instead of paying the single premium upfront, you make the soul (sic) payment later.

The interesting thing is that their argument sheds light not only on the climate change problem, but also on the problem of investing a portfolio. The analogy just presented is not a stretch. It may even tell us as much about the solution to a long-standing investment conundrum as it does about the response to climate change.

It’s all about the (fat) tails

For at least 30 years economists have pondered why the equity premium – the return that investors receive for investing in equities, over and above what they receive for investing in fixed income – has been so high. Virtually 100% of the time historically, equities have outperformed fixed income over investment horizons of 25 or 30 years or more. Then why do investors with those time horizons still allocate so much of their portfolios to fixed income – helping to assure, by keeping the demand for equities low, that the equity premium will continue to be high? This riddle has been dubbed the “equity premium puzzle.”

The origin of the riddle derives from a paper by Rajnish Mehra and Edward C. Prescott published in 1985, “The Equity Premium: A Puzzle.” In that paper, Mehra and Prescott concluded, based on an intricate economic argument, that the equity premium should actually be less than one-tenth of what it has been. Though their argument is borderline credible at best, it is still puzzling why long-term investors would invest in fixed income when equities virtually always do much better.

Wagner and Weitzman have the answer to that, though they mention it only in passing in the process of making their argument for greater investment in climate change prevention.

It’s all about the tails of the distribution; whether those tails are fat or not is relatively unimportant. On the extreme tail of the distribution of equity returns lies disaster. That extreme tail may have a probability that can be estimated – such as 1%, or even less – or it may fall into the category of unmeasurable “Knightian uncertainties,” “Black Swans” or “unknown unknowns.” Whichever it is, if it actually occurs, it spells catastrophe for the investor, who would find herself without enough money to live.

Is that vanishingly small chance of calamity enough to be concerned about? It would seem to be. Potential economic-survival-threatening disasters with such small probabilities usually call for insurance. There’s less than a 1% chance that your house will burn down, but you buy insurance for it anyway. That purchase of insurance comes at a very high cost. Buying an insurance contract in case your house burns down is a very risky investment, considered in isolation. There’s less than a one percent chance that it will pay off at all and greater than a 99% chance that you’ll lose all your money. And yet, in spite of how risky that investment is, its expected return is negative. That is the measure of what a high cost we are willing to pay to insure against disaster.