Climate change poses a significant risk to portfolios — but how investors should manage that risk depends on their time horizon, researchers argue.
In a new study, Mathijs Cosemans, Xander Hut, and Mathijs van Dijk from the Rotterdam School of Management at Erasmus University looked at the implications of climate change on equity risk and how investors should factors those risks into their portfolios.
They found that investors who incorporate the long-term risks of climate change into their portfolios are more likely to view the stock markets as riskier over longer horizons. The researchers explained that this is because natural, climate-related disasters often occur in clusters, which are connected to high temperatures. In other words, a natural disaster is likely followed by another natural disaster.
“As a result, it 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 told Institutional Investor in an email.
Based on their findings, the researchers concluded that the investor who takes climate change into account should buy more equities in the short-term than the benchmark investor. That’s because in the short term, the future risks of climate change should result in higher risk premiums for equity investors.
As the risks of natural disasters increase over time, however, the climate-aware investors should invest less in the stock market, according to the researchers. In fact, the study found that these investors will allocate about 15 percentage points fewer to equities than the benchmark investor over 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. Therefore, climate change seems to affect short-term investors and long-term investors differently.”
The study’s implications are two-fold, Cosemans said. First, when incorporating climate change into a portfolio’s long-term outlook, there is a sharp increase in equity risk and higher risk premiums.
“These effects need to be balanced: more risk for more reward may still be a good choice, but it could also be that the reward at some point is insufficient for the risk,” Cosemans said. “If the latter is the case, one should buy less risky assets. Our work shows how to optimally balance the additional risk and return stemming from climate change.”
Second, the findings showed that investors’ beliefs about climate change have an impact on optimal portfolio choices for long-term investors, like pension funds and insurance companies. The researchers suggested that investors consider three key parameters when factoring in the potential impact of climate change on their portfolios: equity premium, the degrees of equity risk over different horizons, and correlations between different asset classes.
“The optimal weight of assets in investors’ portfolios will increasingly depend on the exposure of these assets to climate risk,” Cosemans said. “As a result, stocks that hedge against climate change will attract additional demand and increase in value, whereas stocks that are sensitive to climate change will become less attractive and experience a price decline.”