Research suggests risk of future natural disasters creates uneven distribution of equity risks and risk premium over time
For many investors, dollar cost-averaging is an effective way to mitigate the risks of investing in the stock market over time. But those considering the effects of global warming and climate change on portfolios might want to take a different approach.
According to a new study from researchers at the Rotterdam School of Management at Erasmus University, investors who consider the long-term risks of climate change on their portfolios are more likely to see the stock market as riskier over the long term, reported Institutional Investor.
As explained by the study’s proponents Mathijs Cosemans, Xander Hut, and Mathijs van Dijk, natural, climate-related disasters often occur in clusters, which is correlated to elevated temperatures. Put another way, one natural calamity is likely to be followed by another, which has implications as catastrophes impact stock market returns.
“[I]t becomes less likely that negative stock market returns are cancelled out by subsequent positive returns, which implies that equity risk increases with the investment horizon,” Cosemans said in an email to Institutional Investor.
According to the researchers, the future risks of client change implies higher risk premiums for equity investors in the short term. The upshot, they said, is that investors who account for climate change should load up more on equities in the short term than benchmark investors.
And as the potential for natural disasters to occur rise over time, the researchers said, climate-aware investors should step away from the stock market. Over the long run, they said such investors will allocate around 15 percentage points less to stocks relative to the benchmark investors in the long run.
“The impact of climate change on equity risk and return strongly depends on the investment horizon,” Cosemans said. “Accounting for climate change increases the equity risk premium already in the short run (in anticipation of future adverse outcomes), but equity risk only increases over the long run.”
According to Cosemans, it may make sense to invest more in equities, but only if the added risk leads to higher expected reward. The study, he argued, demonstrates how the additional risks and returns from the impact of climate change may be optimally balanced in a portfolio.
Beyond the equity premium and equity risk over various time horizons, the researchers also suggested that investors should consider how vulnerable different investment holdings are to climate change.
“The optimal weight of assets in investors’ portfolios will increasingly depend on the exposure of these assets to climate risk,” Cosemans said.
