Financial advice for the individual investor like you has been the same for decades: invest for the long-term by buying and holding diversified assets (i.e. index funds) and you will benefit from inevitable market growth while shielding yourself from short-term dips.
While this investing strategy has been the basis of pensions, individual retirement funds, and other sources of personal wealth for a long time, there is a growing threat that puts into question the very assumptions on which it lies. How will climate risk affect your money?
The Climate Issue
I recently was reading a report from Propublica illustrating the wide and devastating effects that climate change will have on the U.S. as early as 2040. In that report is a graphic that would make any economist or investor cringe.
This map demonstrates the estimated impact on GDP that in each county of the US will experience between 2040-2060. Although the report did not calculate a net effect for the entire US GDP, you can imagine that if the damage is not net zero or net negative based on this map, it’s only a matter of time.
The report took into account four main effects of climate change: extreme heat and humidity, large wildfires, rising sea levels, and farm crop yields. As you can imagine these changes affect all regions differently, but taken together, they will form a complex web of devastation that is likely to fundamentally damage our current economy.
With extreme heat will come less productivity for construction and outdoor services. It will increase fuel and electricity prices as we try to maintain habitable conditions inside. It will also threaten the viability of crops and may even require us to replant certain crops farther north than they are now.
Large wildfires will transplant millions of people from their homes taking their businesses and consumption elsewhere as well. It will devastate local tax bases and leave whole cities and towns in ruin.
Rising sea levels are out to get most of our southern and eastern coast: places that boast our highest real estate values and most popular vacation destinations. It will cause cities and municipalities to pour hundreds of millions if not billions into artificially protecting the coasts.
All of these economic effects are just a sampling of what is to come from the already very serious environmental impacts we are experiencing and have yet to experience.
How Does This Affect Your Money?
All of this leads me to ask the very scary question that it seems nobody is willing to ask: If our world is fundamentally damaged, will our economy and markets be fundamentally damaged as well?
I ask this question not out of greed or insensitivity toward the main issue which is saving our planet. Rather, I ask it out of the very real concern for the fate of all the millions of Americans planning for the future with the assumption that the future will look like the past.
We can’t continue blindly following traditional long-term investment strategies like investing in index funds if we don’t at least start a conversation that explores the possible fallout that these climate change effects could have on our financial futures.
A Typical Retirement Trajectory
Conventional wisdom and advice along with everything I normally talk about on Two Cents follows a similar refrain. The idea is that investing in your 401(k), IRA, and other accounts by purchasing broad market-based assets like index funds and ETFs will almost guarantee a comfortable and secure retirement.
The general roadmap sketched out for building a robust retirement fund is to start out investing in your 20s-30s, contribute a set amount each month into your accounts, and adjust for your risk profile as you get older by investing in less risky assets like bonds.
This graph will show you how this investment strategy is expected to lead your retirement funds to grow over time. It assumes that you contribute $250 per month for 45 years earning 7% annual returns.
As you can see, the compounding behavior of money is key to reaching the retirement goal. Without it, your money would grow much more slowly, and it would be nearly impossible to retire with the same amount that you could with your money growing at 7-10% annually.
There are a few assumptions that back this advice that almost everyone takes as a given.
- Markets will continue to grow in ways comparable to the past. This means that we can expect a 10% average long-run annual return on equities, and a 7% average long-run annual return for balanced portfolios (equities and bonds) especially when accounting for inflation.
- Inflation will continue to hover around 2%. This will erode the buying power of your savings, but since you are investing in assets growing faster than inflation, it’s okay.
- You can adequately plan for the cost of living by using current relative prices to estimate your monthly expenses in 30-40 years. Cost of living will only change based on inflation, but no other factor.
I think that the main threat that climate change poses to the typical retirement trajectory is in assumption #1. Assumption #3 also may have some implications we can discuss. To avoid getting too technical and off topic, I will skip over assumption #2.
A Primer on Markets
Before we dive into a discussion about whether climate change may affect the long run performance of the markets, I first want to explain the fundamentals behind the stock market. What is it and how does it work?
For the purposes of this discussion, I am focusing on U.S. markets. There are two main measures for “markets” in the U.S. The first is the S&P 500 which measures the performance of the biggest 500 companies. The second is the NASDAQ which measures the performance of almost all the stocks in the U.S.
In simplified terms, when the majority of the market does well, the indexes representing the market will grow. So, when we say that the S&P 500 increased 7% in one year, that means that the total value of all the companies included in the S&P 500 grew by 7% collectively.
This aggregate growth of the companies making up those indexes is what is good for your retirement accounts. It is what makes your small share of the index funds or ETFs that track the markets go up in value. It is why $1 today when you are 20 years old can be worth $15 at retirement.
Does Climate Change Threaten Average Market Return?
After breaking down how the growth of markets can lead to our own personal retirement accounts growing, it begs the questions of what happens if the growth of the economy and, therefore, markets suffers from the effects of climate change?
As you saw in the map, large swaths of the economy are expected to take a financial hit whether it be from decreased productivity or increased liability due to damages from devasting environmental effects.
As you can imagine, this will affect the ability of companies to grow as they have done without exception in the past. This will likely be reflected in the markets. Will it be possible for equity markets to gain 10-12% each year as they have done in the past when GDP in certain areas of the country is declining up to 40-50%?
This thought really worries me because there is not much awareness and discussion in the mainstream conversation about how climate change will affect average people’s financial futures.
It is hard to imagine a future where market behavior is fundamentally changed. In the past, periods of decline were caused by endogenous factors like decreased investor confidence or the adoption of too much risk by investors. This is a much scarier situation were the hit to the markets will be exogenous—caused by an outside force.
With scientific evidence pointing to permanent long-term damage from climate change, it’s very possible that we could be headed into an unprecedented shock to the markets that will be very hard to bounce back from.
What’s Next?
My main goal of this article is to stimulate public awareness of a very salient issue that will affect every single person with an investment account. I don’t believe that many have made the connection between personal finance and climate change, yet. Whether that’s out of fear or denial, it’s damaging to ignore such an important link.
I’m not quite sure what it is I’m proposing. What I do know is that I’m not calling for you to pull out your investments or give up hope. I really believe that collective action is the solution.
However, action is the keyword here. I am encouraged by the call to action in government and many industries surrounding decarbonization, however, I think that the financial sector is way far behind. One of the main reasons why I’m concerned about how financial markets will react to climate change is the very fact that they aren’t fully acknowledging it, yet.
Sure, we can’t prevent the physical damage that will cause companies to lose productivity and eventually profits, but one thing we can do is start pricing in these risks in the market, now. Currently, investors are grappling with finding ways to adequately price in climate risk. The longer it takes them to do that, the greater chance we have of facing a large economic crisis marked by a huge market downturn.
Once we start pricing in climate risk, companies that are doing the correct things to mitigate their risk and work towards a more sustainable future will be valued higher than others. Not only will this process create healthier markets, it will funnel investment to the companies that are integral to building a more sustainable future, further improving our chances of building that future.
Further Reading
The last few paragraphs discussing climate risk in financial markets was informed by some recent important articles and reports by experts and think tanks. If you are at all interested in this topic, I highly recommend starting here to continue your reading!