Principles of Sound Investing
A broader concept of sound investment
This principle is different from the others because it broadens the idea of "sound investment" to include more than the pursuit of good financial returns. Many investors wish to select investments that will not only meet their personal financial objectives, but also contribute to a better society. They would like the companies in which they are shareholders to be working toward desirable social goals, or at least trying to avoid doing harm.
Social investment funds
A number of mutual funds now specialize in socially responsible investing, and their assets have been growing rapidly. Today about one out of eight investment dollars flows into this type of investment. A lot of that money comes from large institutional investors like pension funds, whose investment decisions can have a large impact on society.
Socially responsible investing takes several different forms. The most common form is screening securities so as to include in a portfolio only those that meet certain social criteria. Many social investment funds avoid investing in companies associated with tobacco, alcohol, gambling, weapons, or animal testing; and many look for good records on environmental protection, human rights, and employment policies. Secondly, funds often engage in shareholder advocacy by voting their proxies in support of responsible corporate policies, or proposing their own resolutions at shareholder meetings. Finally, a few funds invest in community development in low-income areas where capital is hard to obtain. These funds may operate community development banks, credit unions and loan funds to help finance small businesses, affordable housing and community services. Socially responsible investing may be referred to as SRI, or more recently as ESG, for environmental, social and governance.
A good source of information on socially responsible investing is the website www.socialinvest.org. It reports the investment policies, performance and fees of many different funds.
A financial sacrifice?
Critics of social investing suggest that investors may be sacrificing superior returns by basing their investing decisions on anything but strictly financial considerations. Some investors might be willing to make such a sacrifice, but they may reasonably ask how large a sacrifice, if any, is involved.
Some of the criticism is based on the assumption that investors can get market-beating returns by investing in the highest-performing mutual funds. Investors who limited themselves to the relatively small number of SRI funds might be overlooking most of the best performers. However, this argument may exaggerate the connection between past and future performance, and as a result underestimate how difficult it is to achieve consistently above average results even with conventional funds (see section 6). In theory, an investor who could always be in the most successful funds would make more money than the social investor, but in practice, most investors who chase performance fail to outperform the market in the long run, and more often underperform it once trading costs and expenses are factored in. It may be more important to compare the social funds to the market averages than to the highest performing funds in any given year.
Advocates of index funds argue that most investors do better in the long run by accepting the average return of the market than by paying active managers high fees to try and select superior stocks. From that perspective, SRI funds are financially sound investments as long as they can offer broad diversification at low cost. At first, a lot of social funds were quite selective and had relatively high fees because of the research that had to go into company screening. Although it is easy to screen companies for obvious things like selling cigarettes, it is much harder to evaluate a company's environmental and human rights record, especially if the company has many different enterprises in many different countries. In 1990, Amy Domini and her associates introduced the Domini 400 Social Index. the first index tracking the performance of large companies screened by social criteria. The appearance of social indexes has allowed some funds to reduce fees by tracking an existing index rather than researching and selecting their own stocks. The Vanguard FTSE Social Index Fund is an example of a low-cost fund that should perform comparably to other index funds. It tracks the FTSE4Good index, which screens companies according to such criteria as environmental sustainability, human rights, labor standards, and avoidance of tobacco products and nuclear weapons.
Even a broadly diversified social fund could underperform the market if the companies it screens out are above-average performers. Some researchers have reported such performance gaps for certain markets in certain time periods, but the differences are usually small.
Your bottom line
In the end, the best investment plan is the one that is most appropriate for your particular goals and circumstances. Your financial goals don't exist in a vacuum, but they connect to your life goals and to all that you care about in your family and your community. Investment income can contribute to the quality of life, but it can also detract from that quality if it comes at the expense of a clean environment or of human rights. Your real "bottom line" is not financial profit, but value however you define it.