Lately the forums have been discussing ethical investing, that is, investing according to personal beliefs rather than financial beliefs.

I can think of two motivations for ethical or social investing.

  1. One does not wish to be associated with companies engaged in certain practices.
  2. One wishes to use one’s money to guide the actions of existing companies.

I’ll deal with these in turn.

In the first case, the consumers of the products that a given company makes have a far greater impact that investors can ever have. If consumers stop buying the company’s product and you will see bottom line losses in the next quarter and that will affect the share price far more than people not buying the shares. For the many companies that are valued by their earnings multiple a 10% drop in earnings will cause a 10% drop in share price.

The reason that social investors don’t have a large impact is that the number of regular investors outnumber the social investors by a large margin. I believe this will always be the case—people can be bought; it’s just a matter of price. Also, not everybody adheres to the same ethical guidelines.

Obviously many engage in unethical behavior by being in denial about their personal impact. My favorite example is the “No war for oil” or the “Keep the planet green” stickers on people’s cars. You could say that companies to some extent generate their own demand through advertising. This, however, is also saying that other people are not capable of making rational choices. Hmmm…

In the second case, investing in stocks essentially means you engage in equity financing. When a company needs money, it can raise the money by borrowing it (debt financing) or equity financing. The equity can be private (your rich uncle) or public (the stock market). If social investors are unwilling to finance the company, the equity sells for less money since there is less demand and thus the price does not get bid up. Hence, the return on investment for those who are not bound by ethics will be higher. This ends the direct involvement of the company: they got their financing.

What happens now is that stocks simply trade on the stock market. Investor X sells a stock to Investor Y but the company never sees any of that money. Given the huge number of small investors and the different classes of shares in terms of voting rights, any individual investor is very unlikely to have any influence on the company whatsoever either.

From this point on, the only effect social investors have in terms of financing is if the company decides to raise more cash through another emission, they will not be able to get as much money as they would have gotten if they were an ethically or socially approved company.

Originally posted 2010-09-14 09:43:15.