by Garvin Jabusch
Jack Bogle is flat wrong. I mean, within his worldview and that of Modern Portfolio Theory, he’s right, but in the Anthropocene, he’s wrong. Bogle, founder and retired CEO of the Vanguard Group, is known for championing the superiority of low-fee index funds. His firm’s largest product, the $155 billion Vanguard 500 Index Fund is the perfect poster child for his philosophy. It closely tracks the S&P 500 Index of America’s largest companies, and it has a fee of only 0.06% inclusive. The S&P 500 has performed better than most actively managed portfolios over time, so Bogle’s thesis of “don’t look for the needle in the haystack. Just buy the haystack!”, and buy it as cheaply as you can, is brilliant in its simplicity. Elegant, even.
Here’s where it fails: investing in a broad index, Bogle’s or anyone else’s, means owning every sector and company in that index. Every sector and stock. Including oil. Including tar sands. Including coal. Including myriad other causes of major yet avoidable risks around water, agriculture, transportation and many other sectors. All the traditional equity market indexes were built by, of, and for the old business-as-usual economy. Index rules of economic sector allocation demand ownership of all areas of the economy that were important when these indexes were devised in the middle part of the last century, before anyone had heard of climate change, could imagine resource scarcity on a global scale, or could fathom 7.3 billion people and a mass extinction event likely to rival the largest in prehistory. There are massive economic risks now that simply did not exist when our stock market indexes and the body of theory that supports them, Modern Portfolio Theory, were devised.
Modern Portfolio Theory has another big limitation: It requires measuring risk by analysis of past performance. It asks, of any stock portfolio, “what would the return for that have been over the last 10 or 20 years, and at what level of risk?” Here again, this seems eminently reasonable, but it has the negative result of making the economic causes of our most threatening risks appear to be wise investments. Today, though, our primary risks are so obvious, and human innovation is advancing solutions so rapidly, that there’s no economic outcome 10 or 20 years hence that looks anything like the last 10 or 20 years. Where legacy economy stocks have traded historically is irrelevant now. Causes of economic and environmental risks, like fossil fuels, are not the safe source of risk-adjusted returns that they used to be. The world has changed, and following Bogle’s advice to invest in an S&P 500 Index fund doesn’t give you much access to this new world of profitable innovation and investing opportunity, but it does keep you invested in the causes of our problems.
Like it or not, we’ve ushered in a new era. It’s the Anthropocene now, yet we’re still largely investing with old Holocene methods.
It’s time for a new investing philosophy, one that reflects what we have learned at last about how to sustainably inhabit the Earth. So, what updates could portfolio construction theory employ? If we believe we can arrive at an indefinitely sustainable and even thriving economy, here are some ideas:
- No more blind use of traditional sector allocations. Even some green, SRI, and ESG funds use the old allocations schemes, and then try to screen out some of the objectionable companies. This won’t work. Instead, we must allocate portfolio investments by evaluating forward-looking risk. It’s time we created portfolios from the bottom up, intentionally, by selecting the economic areas to invest in via risk-factor allocation, rather than traditional sector allocation methods. That is, we must stop investing in causes of systemic risks, wherever they may exist, and start investing in the most economically exciting, innovative solutions to those risks, economy-wide. Continuing to invest in all sectors of the economy regardless of the risks that a given sector has to our future viability has no place in today’s investing world.
- Stop evaluating risk using backward-looking models. In order to create portfolios that accurately factor in today’s and tomorrow’s risk continuums, investors need to change their paradigm and begin using forward-looking economic modeling. Innovation is far more rapid now than at any time in all human history, and we can finally now bring to investing a vision of where the economy is going, and where it should go, in both economic and sustainability terms. Modern Portfolio Theory’s rearview mirror approach to risk evaluation can actually be said to violate the causality principle in physics, in that it expects past outcomes to emerge from present events. They won’t.
- We must each be aware that the rules, habits, and institutions of the past do not have to bind the future, and indeed they must not. We must be aware of as much as we can, studying science and basic principles, and working hard to suggest new, better ways forward.
We can’t acquiesce into accepting that the framing of investing for the future can be achieved within the terms of Modern Portfolio Theory, which was developed in the 1950s with no knowledge of the world of 2015. We can’t work on evolving our economy from within the terms of that frame. To the extent that we could, it would be far too slow. As Jacob Goldstein, host of NPR’s Planet Money, said of Paul Volcker’s comments to him regarding fighting another systemic risk, the runaway inflation in the 1970s, “Volcker told us that in the ’70s the Fed had tried doing things gently, and it didn’t work because it didn’t convince people. You know, he said gently wasn’t enough to change what was in people’s heads to make them really believe” (Episode 664: The Great Inflation).
Our ability to do all this will depend on the rigor of our economic models in factoring realistic risks related to climate change, resource scarcity, and population growth, paired with innovation and solutions. A holistic model of what it will take to fit human civilization less awkwardly and less destructively into the rest of biodiversity and, beyond that, into the fundamental conditions and physical limitations of Earth, won’t arrive any time soon. The problems and systems involved are too complex.
Nevertheless, we have to take strides toward understanding our place in, and effect on, the world represented by that model. Because in full light of what we now know in 2015, the consequences of continuing to accept investing advice rooted in the outdated dynamics of the legacy economy, even from a mind as brilliant as Jack Bogle’s, will cause our environmental and economic situations to rapidly become unimaginably worse.
Garvin Jabusch is cofounder and chief investment officer of Green Alpha® Advisors, LLC. He is co-manager of the Shelton Green Alpha Fund (NEXTX), of the Green Alpha Next Economy Index, the Green Alpha Growth & Income Portfolio, and of the Sierra Club Green Alpha Portfolio. He also authors the Sierra Club’s green economics blog, “Green Alpha’s Next Economy.”