Long-term investors will need to adopt next-generation strategic asset allocation practices to successfully play their part in a rapidly changing world. Traditionally accepted truths, practices, and principles face reduced significance and potential obsolescence.
This is the fourth article in a series where we examine the key topics and expected changes to how investors can make decisions with multi-horizon strategic asset allocation. Below, we examine how multi-horizon analysis can play a crucial role in helping investors plan for the impacts of climate change.
How Humans Perceive Risk
Humans, in general, make poor decisions when assessing risk; often overestimating the odds of rare events and underestimating how dangerous more commonplace events are.
Risk-communication consultant Peter Sandman uses the following framework (Sandman 1987, 21-22) to describe the human perception of risk:
Risk = Hazard + Outrage
Hazard is the objective impact of risk, such as mortality rate or sea level rise; outrage are all other factors such as:
Control – Where prevention and mitigation are in an individual’s hands, the perception of risk is lower; think driving vs. driven
Fairness – Risks that impact everyone rather than a particular group are more acceptable. (e.g., risks that could affect only children cause more outrage than risks for adults and children)
Familiarity – Exotic things and locations are perceived to be at higher risk than more familiar items and locations (e.g., venomous insects vs. cigarettes)
Natural – Earthquakes and volcanos are more acceptable than oil spills and industrial chemical leaks
Diffusion in time and space – Hazard A might kill 50 anonymous people a year across the country, while Hazard B has a 1-in-10 chance of wiping out a neighborhood of 5,000 in the next decade. Both hazards have the same expected annual mortality, yet the outrage component tells us that A is more acceptable than B.
The combination of hazard and outrage is how individuals perceive risk. In many cases, the way to increase or decrease public perceptions of risk is by dialing up or down the outrage factors.
“Outrage” for Climate Change
It’s easy to see the nature of climate change is such that it naturally scores low on many of the outrage factors.
Control – Most of the control for a response to climate change is in the hands of governments; not a single government either, but all governments
Fairness – While some groups will be more heavily impacted than others by changes in the climate, no group will be unaffected
Familiarity – Many of the early impacts of climate change will be familiar; warmer summers and colder winters don’t seem exotic
Natural – More extreme weather, temperatures, and flooding are all natural phenomena
Diffusion in time and space – The impacts of climate change will play out over decades. It was easier to coordinate government responses to the fast-moving COVID-19 pandemic than slower-moving climate change
It seems that humans are wired in a way that makes risk perception of climate change lower than it should be.
That means government responses to climate change have been slow and inadequate. The perception of risk of climate change must be higher to trigger the full force and urgency of government coordination required. You just need to look at the response to COVID-19 to get a sense of what is possible when all organizations are aligned to a single cause.
The “Problem” with the Climate Change Problem
The problem with the climate change problem is that we need to do better with both the hazard and outrage components. In many cases, the objective measures of hazards are understood by all parties (e.g., the impact of smoking on mortality rates). This is not the case for climate change.
In an investment context, the traditional tools for forward-looking (ex-ante) analysis of investment risk depend on two key ideas, the first is usage of historical market data as an input into models and the second is to analyze scenarios or stress-tests.
What makes climate change so challenging to analyze is that:
- We can no longer rely on historical market data as an input since financial markets have never experienced climate change
- Scenario analysis (i.e., stress-tests) typically show instantaneous portfolio impacts; the impacts of climate change will play out over years and decades
Enhancing the tools and techniques used to think about and analyze the “hazard” of climate change should be high on the agenda for long-term investors.
A Multi-period Solution?
According to the 2021 article, “Entrenched risk-management practices will yield to climate trends,” (He and Leatherman 2021) the industry needs to evolve to make better use of projections. This involves replacing historical price changes, and assumptions of stability, with views appropriate to the investment horizon and are not static over time. (i.e., Scenario Analysis with multi-period (time-varying) inputs).
In our previous article, we illustrated how multi-horizon risk measures should be more heavily used by long-term investors. The same techniques can be applied to evaluating the impact of climate scenarios on a portfolio. In addition to capital market assumptions for return and risk, another input to consider is the price impact of NGFSv2 climate scenarios from Planetrics.
Measuring the Hazard
We prototyped a novel approach during FactSet’s 2022 Hackathon. Comparing a portfolio with and without the impact of a Divergent Net Zero Scenario gives an objective view of the Hazard element of climate change on an equally weighted portfolio. The shaded area in Figure 1 shows the expected investment impact of a Divergent Net Zero Scenario forecasted until 2050.
Figure 1 Source: FactSet & Planetrics
Better measurement of the potential impact of climate change can help drive the outrage and therefore the risk perception, leading to more action.
The benefit of a multi-period scenario approach relative to the more traditional instantaneous stress-test is that to many investors, the journey is as important as the end result. While an instantaneous stress test of the above comparison will yield the same ending portfolio results, multi-period analysis can yield much richer information that can be used to create a better investment strategy.
Figure 2 Source: Planetrics
Better measurement and understanding of the impact of climate change (the hazard) has the possibility to impact the levels of outrage and ultimately public perceptions and responses to stem climate change. Holders of the world’s capital have a crucial part to play in the fight against climate change.
Here are links to previous articles in the series:
With thanks to Hackathon teammates: Todor Bilarev, Matthew Ko, and Stoil Yanchev
This blog post has been written by a third-party contributor and does not necessarily reflect the opinion of FactSet Research Systems Inc. FactSet makes no guarantees as to the accurateness, quality or completeness of the information and will not be responsible for any errors, omissions, or inaccuracies of the information or for any reader’s reliance on the information.