February 25, 2012
Lydenberg's Argument for Reasonable Investment Wins IRRC Award
by Robert Kropp
Steven Lydenberg, Chief Investment Officer of Domini Social Investments, wins the first Post-Modern
Portfolio Theory award from the IRRC Institute for his paper espousing reasonable, rather than
merely rational, investment.
The IRRC Institute inaugurated its
annual research awards for Post-Modern Portfolio Theory this month, and Steven Lydenberg, Chief
Investment Officer of Domini Social
Investments, received the practitioner award for his paper entitled Reason,
Rationality and Fiduciary Duty.
Menachem Brenner and Yehuda Izhakian received the
academic research award for Asset Pricing
and Ambiguity: Empirical Evidence.
Lydenberg is a 30-year veteran of the
sustainable investment industry, having co-founded KLD Research & Analytics in 1988. KLD is widely
recognized as having been the first environmental, social, and corporate governance (ESG)
investment research firm in the world. Its sustainability metrics became the standard with which
investors evaluated the ESG performance of corporations.
In accepting the award from the
IRRC Institute, Lydenberg said, "As a long-time practitioner of responsible investment, I have
often sought a vocabulary to adequately express the theory that rests behind our daily practices."
He has done more than successfully develop an adequate language for his enterprise; the ideas he
expresses in his award winning paper are so clearly articulated that it reads as an essay rather
than a research paper. It is, moreover, an essay that anyone concerned with sustainability in the
broadest sense should read.
Modern Portfolio Theory argues that the only responsibility of
fiduciaries is to the financial returns of their portfolios, without regard to the needs of the
economy as a whole, society, or future generations; indeed, in the view of the rational investors
who have embraced the theory in increasing numbers in the last half-century, "Any concern outside
that of the portfolio-level returns was an abuse," Lydenberg writes.
Implicit in the
theory is the justification for a short-term investment horizon, as well as other strategies to
gain advantage in an essentially zero-sum game. Lydenberg points out the degree to which capital
markets have come to be dominated by short-termism: "the average holding period for stocks in 1960
was 100 months (8 years). By 1970 it had dropped to 63 months (5 years). By 1980 it had dropped to
33 months, by 1990 to 26 months, by 2000 to just 14 months, and in 2010 just six months."
The effect of short-termism has been increased volatility in the markets. One of the effects of
trying to gain advantage over less sophisticated investors to increase returns was the creation of
complex financial products that led directly to the financial crisis and a global economic
Against the rational approach, Lydenberg proposes the reasonable fiduciary, for
whom the financial markets cannot be separated from the interests of society, or, for that matter,
future generations. Although institutional practitioners of reasonable investment have been around
for many years in the socially responsible investment (SRI) movement, perhaps the most significant
impetus for a more widespread uptake of the reasonable approach was the publication, in 1987, of
the report by the Brundtland
The report defined sustainability as "development that meets the needs of
the present without compromising the ability of future generations to meet their own needs." The
reasonable fiduciary is one that does the same, as well as accounting for other factors such as the
price of externalities and the distribution of wealth.
Because Modern Portfolio Theory is
inadequate for anything more than maximizing short-term returns, "an increasing number of
institutional investors have begun exploring ways in which essentially reasonable approaches to
investment— that is, those that take into account the effects of their investments in the real
world—can supplement their current practices," Lydenberg writes.
The categories into which
rational investment falls include universal ownership, which considers large institutional
investors as essentially "owning the economy;" therefore, their returns on investment over the long
term are dependent upon the continuing good health of the overall economy.
categories include the sustainable or responsible approach, in which externalities such as
environmental impacts and social factors are integrated into the investment process. And a
norms-based approach ensures that investments are consistent with such widely recognized standards
as the Brundtland report, or, more recently, the Guiding Principles on
Business and Human Rights, which were endorsed last year by the United Nations Human Rights
Although basing investment decisions on considerations of the interests of
others, including future generations, is fraught with uncertainty, reasonable fiduciaries are
better equipped to do so because they are willing to consider what the paper terms "irreducible
uncertainties" through common sense and such non-financial approaches as "conventions, stories,
rules of thumb, habits, traditions in forming our expectations and deciding how to act."
In observing that governments have the responsibility to reduce uncertainty, Lydenberg echoes
the persistent call of sustainable investors for government policies that clearly support such
trends as the transition to a low-carbon economy and the elimination of human rights abuses in
corporate supply chains.
However, Lydenberg points out, reason cannot "supersede or
replace rationality as the driving force in investment. In fact, the two not only can coexist but
need to complement each other in practice."
"We have reached a point in the financial
world where rational behavior has been extended beyond the limits of its usefulness, Lydenberg
concludes. "Reasonable considerations…are better able to cope with those questions of long-term
value creation, environmental sustainability, and social justice that will increasingly confront us
as we move into a technologically advanced world of nine billion persons with all the desires and
aspirations of highly developed societies."
In his paper, Lydenberg lays out his argument
for the evolution of financial markets in clear language, without simplifying the issues and
challenges involved. Reason, Rationality and Fiduciary Duty deserves a wide readership.