Divesting reduces investment risk: Part 1

Lazy arguments against divestment say that people who divest make financial sacrifices. Baloney. In fact, the opposite is true. One false idea says that if you take money out of the fossil fuel industry, your investment position will be riskier – because your money is less spread out (i.e., less diversified) after fossil fuel divestment. Let’s look at that.

Most people who have stock market investments put their money into diversified mutual funds or exchange traded funds (ETFs). To state the obvious, diversified funds do not invest a big percentage of money in any one industry. If you look at the data, you’ll generally find that somewhere between 0–4% of these funds’ stock holdings are in any single industry. Without doing any math, you might conclude that pulling out of one sector (i.e., fossil fuels) can’t possibly have much impact. And you’re right.

To drive that home a bit let’s look at a hypothetical fund we’ll call the “Incredibly Neutral Mutual Fund (INMF).” The INMF manager’s general performance turns out to be supremely neutral. Somehow, with all the ups and downs of all the industries in the fund’s portfolio of stocks, the gains of all the stocks that do well are exactly counteracted by the stocks that do poorly, so every year the fund’s annual return is 0%. But there is one exception to all this – the fund’s investments in the fossil fuel sector.

To make is simple, let’s say that INMF invests 2% of its investors’ money in fossil fuel companies. And the INMF fund manager has a very strong ability to pick fossil fuel winners (and avoid losers) over the 10 years and has a consistent return of 5–10% for the fossil fuel investments. The annual total return to you as a fund investor will be 0.1–0.2% per year. If you had invested $5,000 in INMF, your first-year return would be a $5–$10. The total cumulative ten-year return range will be a meager $50-$100 (slightly more due to compounding).

Here’s a far more important point. New stocks that replace the fossil fuel investments could be clean energy companies. Given where the world is going, these will do better over time than the dying fossil fuel company stocks. In which case, the divestor does better than other investors.

Pulling out of the fossil fuel sector does not make the investments riskier.

More to come on this topic in Part 2 (coming soon) …