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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 recession.

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 Commission.

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.

Other 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 Council.

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.


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