One of the largest barriers to the institutional fossil fuels divestment movement is the evasive myth that divestment is wildly costly.  This argument stands firmly on the study authored by Mark Kritzman and Timothy Adler.  The paper is based on a complicated mathematical model (called Monte Carlo simulation) and, after the method flies over the head of non-financial professionals, we are hit in the face with their bold conclusion, “A socially motivated investor can either exclude bad companies from her portfolio and thereby sacrifice vast sums of wealth through time or invest in an unrestricted fashion …” (p55).  Professor Ruud of Vassar College broke it down and recently published a response explaining the Kritzman-Adler model – uncovering the misconceptions, assumptions and fictional realities underlining their conclusion.

Here are a few gems from Professor Ruud’s extensive critique. Each of these points are paraphrased:

  • Kritzman boils the reality of investing and the difference between unrestricted investing and socially responsible investing down to only two general facts, the variation in stock returns and the average market return – ignoring all other factors including historical trends and general market context.
  • Unfortunately, what Kritzman does not take into account is the reality of the market.  As financial professionals know, returns are uncertain, managers are imperfect, and optimal rarely means maximum expected return. Even in Kritzman’s fictional model, a static world with managers who often make perfect predictions and care only about maximum returns, does not prove that divestment would be costly.  Instead, the costs could be almost anything, from zero to even bigger than he claims.
  • Kritzman’s model does not include well-accepted aspects of active portfolio management including accounting for significant relationships among returns, diversifying risk, and balancing risk with expected return (meaning the balance between the desire for the lowest possible risk of earning less money or losing money and the highest possible return).
  • In Kritzman’s model, active portfolio managers don’t have the (very real) ability to find alternative investments that provide effective substitute for investments removed for socially responsible reasons.  Instead, the model assumes that after a portfolio has an element divested (like fossil fuels) the management would select randomly from the universe of stocks and bonds to fill the hole.  In short, Kritzman’s model includes carelessness as part of the Socially Responsible Investing (SRI) investment strategy.
  • Kritzman’s model has very unusual scales.  First, the model assumes there are only 500 securities in the market – in reality there are closer to 63,000 publicly-traded companies worldwide – and that socially responsible investors are picking from only 400 securities. Furthermore, the Kritzman equation assumes the portfolios contain 250 securities or half the available market.  As active SRI management goes, this is very abnormal and would be a ridiculous representation to base SRI management off of.
  • Kritzman hides the uncertainty about costs implied by his own model.  Though he gives big numbers he does not point out that the predicted probability of incurring positive costs is about a half.  It’s actually a coin toss in his calculations whether SRI costs you or benefits you.

In Professor Ruud’s words, “[this is] an untested and highly simplified model calibrated with crude statistics and arbitrary parameter values which yields numbers that deserve skepticism.”

Kritzman has shopped around his study in a variety of venues claiming his method is an accurate measurement of the expected costs of divestment. As Professor Ruud points out, the study clumps together different types of active management and characterizes them generally – without looking at specific active management strategy.  In fact, the study made no reference to the oil, gas or fossil-fuel industries. The removal of all fossil fuels from a portfolio will have specific financial implications relating to the behavior of the specific stocks and their role within a diversified portfolio – not to be found in Kritzman’s study.