Energy Investing for Beginners, Part I, gave information to guide the choice
of green investment vehicles (mutual funds, ETFs, or stocks.) This article is
intended to help investors decide how much of their money to put into those
An informed decision of how much to invest in green energy is at least as
important as how you make the investment. The
choice between green Exhange Traded Funds (ETFs) and green Mutual funds rests on a difference of
about one percent per year, caused by differences in
in the first three quarters of 2009, the S&P 500 (general stocks) returned
17%, ICLN, a green ETF returned 21%, and my ten green stocks for 2009 returned
41%. With differences between performance as large as 20-30% a year
(green stocks did much worse than the market as a whole in 2008,) the decision
between investing 10% of your portfolio or 60% of your portfolio in green
stocks will make a large difference (8% to 12%) in your total returns for the
year, far more of a difference than how you invest. The other important
factor will be sector
selection within green energy. I believe that the main reason my Ten
Green Stocks for 2009 have done so much better than the benchmarks is
because I emphasized sectors I believed would benefit from the
stimulus package. At that time, the stimulus was only something that I (and
other green commentators) were predicting
as part of Obama's response to the financial crisis (He had not yet been
Your Allocation Decision
How much of your savings you put into green energy will depend on two things:
- Your risk tolerance and market expectations.
- Why you are investing in green energy in the first place.
Most people should not try to time market moves. Endless studies have
shown that small investors tend to put their money into the market near market
peaks (1999 or 2007, for instance) and withdraw that money near troughs (2002 or
early 2009.) The economics of supply and demand make this inevitable: the
more people want to buy stocks, the higher demand for stocks is, and the higher
prices rise. The more people who want to sell stocks, the larger the supply of
stocks is, and the lower stock prices will fall.
This may sound like circular reasoning (do stock prices peak because buying
peaks, or does buying peak because stock prices peak?), but circular reasoning
is the only way to understand stock prices. The price-setting mechanism
itself is circular. George Soros called this
"reflexivity" in his classic book on market trends, The Alchemy of Finance. Most people want to buy when they see prices rising,
causing prices to rise more. Most people want to sell when they see prices
falling, causing prices to fall more.
Hence, most people will
get market timing wrong, and that is why your
investment advisor is always telling you not to time the market. However,
understanding the psychological mechanisms which cause most people to be wrong
about market timing can let a minority of investors take advantage of these predictably irrational decisions.
Since June, I have felt
that we're near a market peak, and have not
changed my mind because of the market advance since then. If you are
reading this in late 2009, and the market has not fallen significantly since the
writing (the S&P closed at 1042 today), I feel it would be irresponsible to suggest that anyone buy green stocks today, without a suitable market
hedge. Hedging is beyond the scope of this discussion, but I have outlined
simple hedging strategies here. If you want a portfolio that is
greener even than the green stocks, ETFs, or mutual funds, you might consider
hedging with shorts on some of the least green companies.
All further discussion in this article assumes that either:
- You have chosen not to time the market.
- You have faith in your own predictive ability, and believe the market will
continue to rise, OR
- Your portfolio will be hedged against major market moves.
Many green energy investments are more volatile than other sectors.
This is because the majority of green energy stocks are not yet profitable, and
do not have the internal cash to see them through hard times. This can
force companies to raise money from the financial markets when those markets
have fallen, and will cause the stock prices to fall further in market
declines. Such stocks are especially concentrated in the domestic and specialty green
ETFs, such as PBW, TAN, and KWT. Most of the green
energy mutual funds, and the international green energy ETFs such as ICLN
are less volatile due to a higher concentration of established companies.
Investors can deal with the greater volatility of green energy in several
- Stick to the less volatile green energy investments.
- Stock investors can emphasize profitable green companies over
unprofitable ones. Almost all of my 10 for 2009 picks referenced earlier
are profitable companies, and those that are not currently profitable
had a history of profitability prior to the financial crisis.
- Stick to the less volatile ETFs that contain a broad base of
profitable global companies, instead of the more volatile domestic ETFs.
- When hedging your portfolio, use a larger market hedge than you would
otherwise. The method I outline in my hedging
strategies article automatically incorporates this adjustment.
- If replacing an allocation of normal stocks with an allocation of green
stocks in a larger portfolio,
- Replace an equally volatile sector allocation with your green energy
- If replacing an allocation to ordinary stocks, replace part of that
allocation with less volatile bonds, and part with green energy stocks.
It makes sense that the more confident you are that green energy will
outperform other sectors, the more money you should allocate to it. Keep
in mind, however, that almost everyone has a strong
overconfidence bias. That is, we believe we are going to turn out to
be right a lot more often than we actually do. This bias persists even
when we are aware of overconfidence bias. Even when we tell ourselves,
"I feel that X has a 95% probability of happening, but I know I'm likely to
be over-confident, so I'll act as if the probability is only 80%," it
usually will turn out that the real probability of X was even lower than our 80%
Hence, we should only let our confidence in green energy have a small
influence in our overall allocation decision. Like market timing, this is
another rule that I honor in the breach: my entire stock portfolio is in some
way related to green energy. In ten or twenty years, we'll find out if I
actually know what I'm doing, or am just overconfident like most everyone else.
Motivation: Doing the Right Thing
If your main motivation for investing in green energy is to be more
environmentally responsible, you are faced with a trade-off: the more you invest
in green energy, the more volatile your portfolio will become. However,
feeling better about your investments may make you more comfortable with the
added volatility. This may allow you to hold more green energy because of
your increased risk tolerance.
However, if you don't believe that green energy will outperform, there are
less risky ways to do the right thing. You could instead replace your
stock holdings with companies that are more green than most companies in their
sector. In a recent paper by Meir
Statman and Denys Gluskov entitled "The Wages of Social
Responsibility", the authors found that socially responsible investment
managers were able to achieve higher returns by favoring "best of
class" companies in each sector, a process they described as socially
responsible "tilt." In contrast, they found that completely
shunning sectors such as alcohol and firearms led to lower returns over
time. Based on theses results, there is a win-win available for
environmentally responsible investors who want to do the right thing: they can
rebuild their entire stock portfolio by keeping the same sector allocations they
had made before the change, but replacing the stocks in each sector with the
greenest stocks from lists such as Newsweek's
rankings of the 500 largest US Corporations that I wrote about in September.
Motivation: Fighting Climate Change
If your motivation for investing in green energy is to fight climate change,
you must balance the trade-off of increased risk from concentration in one
industry, with your expectation that that industry will produce higher long-term
returns because of increasing regulation of greenhouse gasses, and support for
alternative energy. In general, I find it very difficult to predict which
companies are going to benefit from climate change regulation. Will
politicians choose to subsidize solar, wind, biofuels, or energy
efficiency? Will carbon credit giveaways create a windfall for utilities
and other large emitters of greenhouse gases.
Not being able to predict politicians, I instead choose to focus my investing
based on the (clearly false) assumption that politicians will do (roughly) the
right thing. While I know this assumption is wrong, I also know I don't know in
which direction my assumption will be wrong: the idea is that the ideal
political action averages out all the likely errors that politicians are likely
to make along the way. How do we know what the ideal actions are? We
look at reports from relatively unbiased sources that recommend particular
actions. I recently wrote two articles based on an article from two
economists that looked at what Modern Portfolio theory has to say about the best
technologies for climate mitigation (here
In terms of how much of your portfolio you should devote to fighting climate
change, if that is your motivation, it should depend on how quickly you expect
the effects of climate change to occur. The biggest gains from a climate
change focused portfolio will occur as more and more political leaders stop
being able to ignore the urgency of responding to climate change. I
personally feel that this will be triggered by the increasing frequency of
climate-related disasters, caused by the increasing severity and frequency of
unusual and dangerous weather events such as hurricanes, droughts, floods, and
blizzards. This is something that I already see happening, but I don't
expect it to be obvious to the many people who want to ignore the effects of climate
change for another 5-15 years.
Based on your own belief of when you expect this political transition to
occur, you should only allocate money to climate change mitigating investments
if you do not need to withdraw that money before the expected political change
is likely to occur. In some ways, this political change has already begun,
money is being awarded to deserving green energy firms. However,
investors should not ask what has already happened, but what unexpected changes
are likely to occur. The unexpected (by most other investors) change
that I expect is the realization that Climate Change will not only be a serious
problem, but that it will be a serious problem in our lifetime, and that it's
worth risking damage to the economy by devoting massive resources to the project
of combating it.
In my case, my investment horizon is about 20-30 years,
which is longer than the 5-20 I expect for the political change, so I consider
fighting climate change as a good motivation to increase my portfolio's
allocation to green energy.
Motivation: Peak Oil
between fossil fuel prices and the performance of green energy stocks is tenuous
at best. Investors should not expect their solar stocks to go up or
down with the oil price. After all, we do not yet have a fleet of plug-in
vehicles which might let us substitute electricity from solar for gasoline from
oil. Hence, investors motivated by peak
oil should stick to green energy sectors which reduce the need for liquid
transportation fuels. These sectors include biofuels, hydrogen fuel cells,
technologies which make transportation more efficient, and technologies such as
batteries which enable the electrification of transport.
Like climate change, how soon you expect to see the effects of peak oil
should affect how much money you invest. I feel that the effects of peak
oil in terms of the reduced affordability of gas and diesel are already upon
us. This does not just mean high oil prices (which we have), but
decreasing ability to purchase oil due to the economic disruption and
contraction caused by those prices. Low oil prices make our economies
vibrant, which provide the money needed to buy oil. High oil prices
cripple the economy, which in turn means that we're less able to buy oil at any
price. This is what I mean be "reduced affordability."
In a recent report, "The
Peak Oil Market," Deutsche Bank predicts that post peak, both oil
prices and oil demand will fall due to the introduction of disruptive
technology: plug-in vehicles (Thanks Nate
Hagens.) If they're right, investing in oil or oil companies is not
the best way to profit from peak oil, but rather the potential disruptive
sectors. Of the sectors I mention above, efficient transportation,
hydrogen, and electrification are the only ones that can possibly scale to
replace a significant portion of our fossil fuel demand. Biofuels are
limited by the available supply of biomass. Biomass
can more efficiently power a vehicle when burnt to produce electricity to charge
an electric vehicle's battery than when converted into liquid fuels for an
internal combustion engine. A similar efficiency argument applies to
hydrogen, although breakthroughs in electrolysis and fuel cell technology could
change this. However, I don't consider betting on possible technological
breakthroughs a sound investment strategy. After all, even if a
breakthrough occurs, it's at least as likely to come from a new player than an
will need some technological breakthroughs in order to make plug-in vehicles
economical enough to displace gasoline. However, the needed improvements
to the electric grid needed to accommodate electrified transportation (as
suggested in the Deutsche Bank report) can be accomplished with existing
technology. Hence, investors motivated by peak oil should be looking to
investments in transport
In terms of how much to invest in these strategies, it probably should be a
lot (at least if you believe as I do that the peak in oil production has either
already happened, or will happen soon), and it should probably be accompanied by
a hedge using shorts in oil intensive industries such as airlines. The
hedge is necessary because a peak in oil supply will hurt the world economy, and
is likely to make stock prices as a whole fall, quite possibly even the stock
prices of the companies which are working to displace oil with disruptive
technology. However, it is a good bet that these companies are likely to
fare better than companies whose economics depends on the large scale
consumption of cheap oil.
Your goals, expectations, and risk tolerance will affect both how you invest
in green energy, and how much you invest. Before you make any decisions,
answer these questions for yourself:
- Do I believe investing
in green energy is the right thing to do? Will this help me bear the
pain of declines in my portfolio?
- How soon will Climate Change reach the top of the political agenda?
Do I have the time to wait for the expected investment returns?
- How soon will oil production peak? Do I have time to wait for the
- How confident am I about my answers? Do I have reason to be
confident, or is my confidence based on self-delusion?
Knowing the answers will help guide your investment allocation.
I don't currently have plans for more articles in this Green
Investing for Beginners series. If you feel there's something I still
need to cover, please leave
DISCLAIMER: The information and trades provided here and in the comments are for
informational purposes only and are not a solicitation to buy or sell any of
these securities. Investing involves substantial risk and you should evaluate
your own risk levels before you make any investment. Past results are not an
indication of future performance. Please take the time to read the full