Investing is an important part of planning for your financial future. One of the hardest parts of investing is deciding how to invest and what companies to invest in. Predicting what companies and industries will grow is like trying to tell the future using a crystal ball.
Although much has been written on finding potentially profitable companies, some people look for more than just profits when they invest. Some people worry about the impact that some companies can have on the world and don’t want to invest in businesses that harm people or the environment.
Environmental, social, and governance (ESG) investing is an investing strategy that involves focusing on companies that work to have a positive impact on the community and the world while avoiding those with a negative impact.
The strategy has grown popular among younger investors, especially millennials, as a way to guide their decision-making when it comes to investing in good companies.
What is ESG Investing?
ESG investing focuses on three factors: environmental, social, and governance.
The environment is the first pillar of ESG investing. Climate change and depleting resources are existential threats that face the world. Some companies’ actions continue to degrade the environment and many businesses act without considering how they are impacting local communities or the planet.
Other companies work to minimize their environmental impact or even actively work to improve the environment. These types of companies can include renewable energy businesses that try to reduce consumer reliance on fossil fuels.
Even businesses that have negative impacts on the environment, like shipping companies that rely on fossil fuels, can try to increase the use of renewable energy or take other steps to reduce the impact they have.
The social aspect of companies — how they interact with society as a whole — is another area ESG investors consider.
One important social element is the diversity of a company and its high-level employees.
For example, almost 90% of the CEOs in the Fortune 500 were white men in 2020, despite white men making up just 35% of the population at large. ESG investors often look for companies that have more diverse executive teams that include women and members of minority groups.
Companies can also have far-reaching social impacts.
Consider a business that relies on overseas labor to produce the goods it sells. Many countries do not have the employee protections that workers in the United States enjoy. Companies in the U.S. may do business with organizations in other countries that treat workers poorly or have them work in unsafe conditions.
This has given rise to certification programs and more transparent supply chains to help consumers feel confident they’re buying products that were not made by exploited workers or people receiving poor treatment.
ESG investors prefer companies with such certifications or supply chain transparency to those that don’t take verifiable steps to ensure the welfare of the people making their products.
This concept can extend into how companies treat their customers. ESG investors look for companies that treat customers well rather than those that rely on predatory practices to increase their profits.
Corporate governance plays a big role in how a company operates and how it interacts with the world. Corporate governance factors include details like the company’s management structure and how much oversight the management team needs to accept, with ESG investors preferring more transparency.
Governance considerations also include executive compensation and the difference in compensation between high-level employees and lower-ranking workers.
ESG investors prefer businesses that have smaller pay disparities between highly compensated workers and rank-and-file employees, and companies that provide good working conditions and support to all employees.
Pro tip: Before you add any ESG companies to your portfolio, make sure you’re choosing the best possible companies. Stock screeners like Trade Ideas can help you narrow down the choices to companies that meet your individual requirements. Learn more about our favorite stock screeners.
Benefits of ESG Investing
ESG investing has many benefits that lead investors to consider it as a strategy.
1. Feeling Good About Your Investments
At the most basic level, one of the benefits of ESG investing is that it can make you feel good. Someone who cares about the issues that ESG investors focus on may feel bad if they invest in companies that don’t fit their ideals.
For example, someone who is concerned about climate change will likely feel guilty if they make money by investing in oil companies that profit from fossil fuels. Those who care about human rights want to make sure workers are treated well.
Sustainable investing is putting your money where your mouth is. Taking that leap can feel good and can help you avoid the cognitive dissonance of saying you care about certain issues while investing in businesses that operate contrary to your stated values.
Socially responsible investing as an investment strategy has become more popular in recent years as more and more people realize the impact that large businesses have on the world and understand the impact that ESG investing can have.
2. Investment Performance
Some investors assume that limiting your investments to ESG companies must come at the expense of maximum investment returns. In fact, this may not be true.
Some experts believe that ESG investments have the potential to outperform traditional investments over time. As more consumers become aware of ESG concepts, they may increase their spending on sustainable companies and reduce the amount they invest or spend with unsustainable ones.
If you believe sustainable companies are a better long-term play, or that consumers will only grow more socially conscious as time passes, ESG investing is a way to try to profit from these trends.
Drawbacks of ESG Investing
Before you start with ESG investing, consider these drawbacks.
1. No Guarantee of Positive Returns
As with all investing, you take a financial risk when you invest using an ESG-based strategy. ESG investing hasn’t been around for long, so there isn’t a huge amount of data on how it impacts financial performance.
Many experts have done studies that show that ESG investing has minimal negative impact on financial returns, but there’s no guarantee that this will continue to hold true in the future.
2. ESG Investing is Difficult
Investing in general is difficult, and it can be hard to identify good investment opportunities in the best of circumstances.
As an individual investor, adding an ESG focus to your investment portfolio restricts your pool of potential investments and adds a layer of complexity to your research.
This can make it harder to find good opportunities and means you’ll have to spend more time managing your portfolio. Being a responsible investor takes effort that some people might not be willing to put in.
If you use a mutual fund or exchange-traded fund (ETF) for ESG investing, these additional difficulties often result in higher investment fees.
3. Qualifying Companies as ESG Investments
The concepts of sustainable and ethical businesses aren’t universal, so it can be difficult to quantify ESG factors that make a company a responsible investment.
Some people may have no issues investing in companies that sell alcohol, tobacco, or cannabis, while other investors might find these products objectionable or immoral.
Some people might want to focus on one specific ESG issue, such as greenhouse gas emissions, while worrying less about the other factors. Others might focus on corporate governance issues.
If you want to invest based on your own beliefs, you have to find an investment manager who has the same beliefs as you or manage your portfolio yourself.
4. No Centralized Certification
Relatedly, it can be hard for investors to learn about a company and decide whether it meets their requirements for sustainability. There are many organizations that work to gauge the sustainability of a business or assign ESG ratings, but these are only as good as the organization doing the rating.
For example, the Rainforest Alliance is an international group that focuses on sustainable activity in farming and forestry and that certifies products that meet its sustainability requirements.
Each organization uses its own criteria to certify companies that it considers “sustainable.” Some may have more stringent criteria than others or focus on just a small number of factors.
There is no single body that can arbitrate and declare a business sustainable, so investors have to do independent research or rely on multiple sources to learn about a company’s sustainability activities.
5. Hard to Quantify Impact
One of the reasons to get involved with ESG investing is to put your money where your mouth is and to support companies that act in ways that you think are sustainable and ethical. Many believe that ESG investing is a way to reward sustainable companies and to encourage other businesses to work toward more sustainable activities.
However, it’s almost impossible to quantify the impact that ESG investing has on businesses. It may make investors feel better about how they invest but they usually can’t see how their investments are affecting the world.
How to Get Started With ESG Investing
If you want to start ESG investing, here are some tips.
1. Define What’s Important to You
The point of ESG investing is investing in companies that act in ways that you feel are sustainable or beneficial for the world. That means something different to each person, so your first step should be to think about what issues are important to you.
Are you concerned about global climate change? You’ll want to focus on impact investing in environmentally sustainable companies and likely will avoid fossil fuel businesses. If you’re less concerned about carbon emissions but want to reward businesses that source their raw materials ethically, you’ll have different investing priorities.
As you’re thinking about the issues that matter to you, write them down. You can refer to these principles when you’re analyzing potential investments or update them as your beliefs and feelings change.
2. Decide How You Will Invest
Once you know your investing priorities, you have to consider how you want to invest. The two main methods of ESG investing are to buy shares directly in sustainable businesses or to invest in mutual funds and ETFs that focus on ESG investing.
The benefit of buying shares in individual businesses is that it gives you complete control over your portfolio and how your money gets invested. You can buy shares only in companies that you personally support and not buy shares in other businesses.
The drawback to this strategy is that it can be difficult for an individual to manage this type of portfolio. You might have to research dozens of companies to find enough that fit your criteria, then make your investment decisions.
Finally, you’ll have to manually rebalance your portfolio on a regular basis. You might also have to pay a lot of commissions if you’re buying shares in multiple companies at once.
This method also makes it hard to build a diversified portfolio unless you have a lot of money to invest.
Investing in ESG mutual funds and ETFs is much easier because the money managers will build a portfolio for you based on ESG criteria. All you have to do is buy and sell shares in one fund.
However, this convenience comes at a cost. ETFs and mutual funds charge management fees, which can reduce your returns.
You also have less control over your investments because the fund managers will choose what securities to buy. That means that you have to find a fund that has sustainability and ethical beliefs similar to yours.
3. Open a Brokerage Account
Once you’ve decided on your priorities and whether you’ll be building a portfolio on your own or investing in mutual funds, it’s time to open a brokerage account. Your decisions will impact the broker you choose.
For example, if you want to invest in individual businesses, you’ll likely want to use a brokerage like Robinhood or SoFi that doesn’t charge commissions for trades. If you have to pay every time you buy or sell stocks, it can add up very quickly if you’re building a portfolio that contains a dozen stocks or more.
Many brokerage companies operate their own mutual funds and ETFs. If you choose a particular ESG fund, such as Vanguard’s ESG fund, you’ll probably want to open an account with that brokerage as investing in its mutual funds often means perks like discounts and better customer service.
4. Choose Companies or Funds That Meet Your Criteria
Once you’ve opened a brokerage account, it’s time to get ready to invest. That means choosing the securities you’ll buy, whether shares of individual businesses or shares in mutual funds and ETFs.
That means choosing companies and funds that align with your ESG beliefs. One good way to find companies and funds that meet your standards is to look at popular and large ESG mutual funds.
Funds publish a list of their holdings. You can use that list to guide your research into companies and learn more about their practices.
You can also do independent research on companies you hear about in the news or are otherwise interested in to see whether their business practices align with your beliefs.
5. Invest for the Long Term
Once you’ve chosen a brokerage and selected your investments, you’re ready to put your money to work. Fund your account and start buying securities.
Two of the most important parts of successful investing are consistency and time. Adding more money to your portfolio on a regular schedule is a good way to grow your savings.
The longer you continue to invest and the longer you keep your money invested, the more likely you are to earn a profit and the larger those profits will be.
Investing is one of the best ways to plan for your financial future. Many believe ESG investing — beyond being the right thing to do — has the potential to outperform traditional investing in the long run.
If you want to put your money where your mouth is and invest in companies that act in a way that aligns with your beliefs, ESG investing is one way to do that.