The hidden risk every investor should be aware of

As I’ve often mentioned, the biggest risk you face as an investor is hidden or unrecognized conflicts of interest. It’s not because any one conflict of interest can do great damage to your finances. The risk comes out of the fact that conflicts of interest are everywhere.

That’s especially so with many ethical investments, also known as ESG (Environmental, Social and Governance) issues. These issues may come with pure motives, but they require outlays that depend on judgment calls rather than financial analysis. Companies deal with these issues by hiring outside consultants and firms to help with decisions. These outsiders supply guidance on how companies should spend their money. The advice they give can raise or lower a company’s profits. This is a potential source of conflicts of interest, for the companies and the consultants.

Alex Edmans is a professor of finance at London Business School and author of Grow the Pie: How Great Companies Deliver Both Purpose and Profit. He is widely viewed as an ESG advocate.

In an August 19 Wall Street Journal article entitled “A Progressive’s Case for Getting Rid of ‘ESG’”, Dr. Edmans wrote, “ESG has outlived its usefulness. It’s time we scrap the term.” He added, “While an incorporation of ESG can enhance financial and social returns, an obsession with ESG can distract companies and investors from both objectives—by causing them to ignore non-ESG factors that may be even more relevant for long-term value.”

This is what you’d call a “high-level view.” However, if you let ESG and related or similar issues influence your investment decisions, it can have a negative impact on your personal finances.

The downside of ethical investments 

Early in my career, I began writing about the harm that conflicts of interest can have on your investments. Back in 2010, I started writing an occasional column for The Toronto Star, on a wide variety of investment issues and questions from readers.

The term “socially responsible investing” was coming into fashion back then. In one of my columns, I addressed a reader’s question about investing in a mutual fund that described itself as socially responsible.

My view—then and now—is that a socially responsible fund may not expose you to any extra risk. It may simply mean the fund’s managers are highly principled and want to do some good in the world. Of course, it may also mean they see the marketing value in declaring their good intentions.

In any event, the best way to get to a destination is generally to go there directly, rather than take a two-stage route. So I advised readers that if they wanted to do some good in the world, they should invest with profits in mind, then give a portion of their gains to a charity of their choice.

After all, the goal of a fund is to make money for its investors, and the goal of a charity is to do good work. If the fund does its job, it will make more money for its investors and attract more of them. If the charity does its job, it will attract more donations and do more good for its cause. Everybody wins.

A few days afterwards, the Star published a note from a reader who was displeased if not outraged about my column, which the reader interpreted as a direct attack on socially responsible funds. I was surprised at how angry he seemed over a simple difference of opinion.

And about that angry letter-writer: He seemed so upset that I wondered if we had had some past disagreement. I found no clue of it when I Googled him a few days later. But I did discover he was a mutual fund salesman who had recently begun specializing in socially responsible funds.

Our Successful Investor approach has a proven record of good investment ideas—and it’s conflict free

Here’s more on our TSI philosophy:

First, invest mainly in well-established companies. When the market goes into a lengthy downturn, these stocks generally keep paying their dividends, and they are among the first to recover when conditions improve.

Second, avoid or downplay stocks in the broker/media limelight. That limelight tends to raise investor expectations to excessive levels.

Third, spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities). This helps you avoid excess exposure to any one segment of the market that is headed for trouble.

What are your thoughts on ethical investments? Have you found that conflicts of interest have resulted in poor growth?