Green Energy Investing for Beginners, Part II

In Green Energy Investing for Beginners, Part I, gave information to guide the choice of green investment vehicles (mutual funds, ETFs, or stocks.) This article is intended to help investors decide how much of their money to put into those vehicles.

An informed decision of how much to invest in green energy is at least as important as how you make the investment. The choice between green Exhange Traded Funds (ETFs) and green Mutual funds rests on a difference of about one percent per year, caused by differences in fees. Yet in the first three quarters of 2009, the S&P 500 (general stocks) returned 17%, ICLN, a green ETF returned 21%, and my ten green stocks for 2009 returned 41%. With differences between performance as large as 20-30% a year (green stocks did much worse than the market as a whole in 2008,) the decision between investing 10% of your portfolio or 60% of your portfolio in green stocks will make a large difference (8% to 12%) in your total returns for the year, far more of a difference than how you invest. The other important factor will be sector selection within green energy. I believe that the main reason my Ten Green Stocks for 2009 have done so much better than the benchmarks is because I emphasized sectors I believed would benefit from the stimulus package. At that time, the stimulus was only something that I (and other green commentators) were predicting as part of Obama's response to the financial crisis (He had not yet been sworn in.)

Your Allocation Decision

How much of your savings you put into green energy will depend on two things:

1. Your risk tolerance and market expectations.
2. Why you are investing in green energy in the first place.

Market Expectations

Most people should not try to time market moves. Endless studies have shown that small investors tend to put their money into the market near market peaks (1999 or 2007, for instance) and withdraw that money near troughs (2002 or early 2009.) The economics of supply and demand make this inevitable: the more people want to buy stocks, the higher demand for stocks is, and the higher prices rise. The more people who want to sell stocks, the larger the supply of stocks is, and the lower stock prices will fall.

This may sound like circular reasoning (do stock prices peak because buying peaks, or does buying peak because stock prices peak?), but circular reasoning is the only way to understand stock prices. The price-setting mechanism itself is circular. George Soros called this "reflexivity" in his classic book on market trends, The Alchemy of Finance. Most people want to buy when they see prices rising, causing prices to rise more. Most people want to sell when they see prices falling, causing prices to fall more.

Hence, most people will get market timing wrong, and that is why your investment advisor is always telling you not to time the market. However, understanding the psychological mechanisms which cause most people to be wrong about market timing can let a minority of investors take advantage of these predictably irrational decisions.

Since June, I have felt that we're near a market peak, and have not changed my mind because of the market advance since then. If you are reading this in late 2009, and the market has not fallen significantly since the writing (the S&P closed at 1042 today), I feel it would be irresponsible to suggest that anyone buy green stocks today, without a suitable market hedge. Hedging is beyond the scope of this discussion, but I have outlined five simple hedging strategies here. If you want a portfolio that is greener even than the green stocks, ETFs, or mutual funds, you might consider hedging with shorts on some of the least green companies.

All further discussion in this article assumes that either:

1. You have chosen not to time the market.
2. You have faith in your own predictive ability, and believe the market will continue to rise, OR
3. Your portfolio will be hedged against major market moves.

Risk Tolerance

Many green energy investments are more volatile than other sectors. This is because the majority of green energy stocks are not yet profitable, and do not have the internal cash to see them through hard times. This can force companies to raise money from the financial markets when those markets have fallen, and will cause the stock prices to fall further in market declines. Such stocks are especially concentrated in the domestic and specialty green ETFs, such as PBW, TAN, and KWT. Most of the green energy mutual funds, and the international green energy ETFs such as ICLN and PBD are less volatile due to a higher concentration of established companies.

Investors can deal with the greater volatility of green energy in several ways:

1. Stick to the less volatile green energy investments.
   1. Stock investors can emphasize profitable green companies over unprofitable ones. Almost all of my 10 for 2009 picks referenced earlier are profitable companies, and those that are not currently profitable had a history of profitability prior to the financial crisis.
   2. Stick to the less volatile ETFs that contain a broad base of profitable global companies, instead of the more volatile domestic ETFs.
2. When hedging your portfolio, use a larger market hedge than you would otherwise. The method I outline in my hedging strategies article automatically incorporates this adjustment.
3. If replacing an allocation of normal stocks with an allocation of green stocks in a larger portfolio,
   1. Replace an equally volatile sector allocation with your green energy allocation, or
   2. If replacing an allocation to ordinary stocks, replace part of that allocation with less volatile bonds, and part with green energy stocks.

Investment Motivation

It makes sense that the more confident you are that green energy will outperform other sectors, the more money you should allocate to it. Keep in mind, however, that almost everyone has a strong overconfidence bias. That is, we believe we are going to turn out to be right a lot more often than we actually do. This bias persists even when we are aware of overconfidence bias. Even when we tell ourselves, "I feel that X has a 95% probability of happening, but I know I'm likely to be over-confident, so I'll act as if the probability is only 80%," it usually will turn out that the real probability of X was even lower than our 80% revised estimate.

Hence, we should only let our confidence in green energy have a small influence in our overall allocation decision. Like market timing, this is another rule that I honor in the breach: my entire stock portfolio is in some way related to green energy. In ten or twenty years, we'll find out if I actually know what I'm doing, or am just overconfident like most everyone else.

Motivation: Doing the Right Thing

If your main motivation for investing in green energy is to be more environmentally responsible, you are faced with a trade-off: the more you invest in green energy, the more volatile your portfolio will become. However, feeling better about your investments may make you more comfortable with the added volatility. This may allow you to hold more green energy because of your increased risk tolerance.

However, if you don't believe that green energy will outperform, there are less risky ways to do the right thing. You could instead replace your stock holdings with companies that are more green than most companies in their sector. In a recent paper by Meir Statman and Denys Gluskov entitled "The Wages of Social Responsibility", the authors found that socially responsible investment managers were able to achieve higher returns by favoring "best of class" companies in each sector, a process they described as socially responsible "tilt." In contrast, they found that completely shunning sectors such as alcohol and firearms led to lower returns over time. Based on theses results, there is a win-win available for environmentally responsible investors who want to do the right thing: they can rebuild their entire stock portfolio by keeping the same sector allocations they had made before the change, but replacing the stocks in each sector with the greenest stocks from lists such as Newsweek's rankings of the 500 largest US Corporations that I wrote about in September.

Motivation: Fighting Climate Change

If your motivation for investing in green energy is to fight climate change, you must balance the trade-off of increased risk from concentration in one industry, with your expectation that that industry will produce higher long-term returns because of increasing regulation of greenhouse gasses, and support for alternative energy. In general, I find it very difficult to predict which companies are going to benefit from climate change regulation. Will politicians choose to subsidize solar, wind, biofuels, or energy efficiency? Will carbon credit giveaways create a windfall for utilities and other large emitters of greenhouse gases.

Not being able to predict politicians, I instead choose to focus my investing based on the (clearly false) assumption that politicians will do (roughly) the right thing. While I know this assumption is wrong, I also know I don't know in which direction my assumption will be wrong: the idea is that the ideal political action averages out all the likely errors that politicians are likely to make along the way. How do we know what the ideal actions are? We look at reports from relatively unbiased sources that recommend particular actions. I recently wrote two articles based on an article from two economists that looked at what Modern Portfolio theory has to say about the best technologies for climate mitigation (here and here).

In terms of how much of your portfolio you should devote to fighting climate change, if that is your motivation, it should depend on how quickly you expect the effects of climate change to occur. The biggest gains from a climate change focused portfolio will occur as more and more political leaders stop being able to ignore the urgency of responding to climate change. I personally feel that this will be triggered by the increasing frequency of climate-related disasters, caused by the increasing severity and frequency of unusual and dangerous weather events such as hurricanes, droughts, floods, and blizzards. This is something that I already see happening, but I don't expect it to be obvious to the many people who want to ignore the effects of climate change for another 5-15 years.

Based on your own belief of when you expect this political transition to occur, you should only allocate money to climate change mitigating investments if you do not need to withdraw that money before the expected political change is likely to occur. In some ways, this political change has already begun, and money is being awarded to deserving green energy firms. However, investors should not ask what has already happened, but what unexpected changes are likely to occur. The unexpected (by most other investors) change that I expect is the realization that Climate Change will not only be a serious problem, but that it will be a serious problem in our lifetime, and that it's worth risking damage to the economy by devoting massive resources to the project of combating it.

In my case, my investment horizon is about 20-30 years, which is longer than the 5-20 I expect for the political change, so I consider fighting climate change as a good motivation to increase my portfolio's allocation to green energy.

Motivation: Peak Oil

The connection between fossil fuel prices and the performance of green energy stocks is tenuous at best. Investors should not expect their solar stocks to go up or down with the oil price. After all, we do not yet have a fleet of plug-in vehicles which might let us substitute electricity from solar for gasoline from oil. Hence, investors motivated by peak oil should stick to green energy sectors which reduce the need for liquid transportation fuels. These sectors include biofuels, hydrogen fuel cells, technologies which make transportation more efficient, and technologies such as batteries which enable the electrification of transport.

Like climate change, how soon you expect to see the effects of peak oil should affect how much money you invest. I feel that the effects of peak oil in terms of the reduced affordability of gas and diesel are already upon us. This does not just mean high oil prices (which we have), but decreasing ability to purchase oil due to the economic disruption and contraction caused by those prices. Low oil prices make our economies vibrant, which provide the money needed to buy oil. High oil prices cripple the economy, which in turn means that we're less able to buy oil at any price. This is what I mean be "reduced affordability."

In a recent report, "The Peak Oil Market," Deutsche Bank predicts that post peak, both oil prices and oil demand will fall due to the introduction of disruptive technology: plug-in vehicles (Thanks Nate Hagens). If they're right, investing in oil or oil companies is not the best way to profit from peak oil, but rather the potential disruptive sectors. Of the sectors I mention above, efficient transportation, hydrogen, and electrification are the only ones that can possibly scale to replace a significant portion of our fossil fuel demand. Biofuels are limited by the available supply of biomass. Biomass can more efficiently power a vehicle when burnt to produce electricity to charge an electric vehicle's battery than when converted into liquid fuels for an internal combustion engine. A similar efficiency argument applies to hydrogen, although breakthroughs in electrolysis and fuel cell technology could change this. However, I don't consider betting on possible technological breakthroughs a sound investment strategy. After all, even if a breakthrough occurs, it's at least as likely to come from a new player than an industry incumbent.

Batteries will need some technological breakthroughs in order to make plug-in vehicles economical enough to displace gasoline. However, the needed improvements to the electric grid needed to accommodate electrified transportation (as suggested in the Deutsche Bank report) can be accomplished with existing technology. Hence, investors motivated by peak oil should be looking to investments in transport efficiency, transmission and smart grid stocks.

In terms of how much to invest in these strategies, it probably should be a lot (at least if you believe as I do that the peak in oil production has either already happened, or will happen soon), and it should probably be accompanied by a hedge using shorts in oil intensive industries such as airlines. The hedge is necessary because a peak in oil supply will hurt the world economy, and is likely to make stock prices as a whole fall, quite possibly even the stock prices of the companies which are working to displace oil with disruptive technology. However, it is a good bet that these companies are likely to fare better than companies whose economics depends on the large scale consumption of cheap oil.

Conclusion

Your goals, expectations, and risk tolerance will affect both how you invest in green energy, and how much you invest. Before you make any decisions, answer these questions for yourself:

1. Do I believe investing in green energy is the right thing to do? Will this help me bear the pain of declines in my portfolio?
2. How soon will Climate Change reach the top of the political agenda? Do I have the time to wait for the expected investment returns?
3. How soon will oil production peak? Do I have time to wait for the expected returns?
4. How confident am I about my answers? Do I have reason to be confident, or is my confidence based on self-delusion?

Knowing the answers will help guide your investment allocation.

I don't currently have plans for more articles in this Green Investing for Beginners series. If you feel there's something I still need to cover, please leave comments here.

DISCLOSURE: None

DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

Comments

[Zenfar:]

Good article. I would also add that Americans need work especially in construction fields, we have already built a lot of houses, let's put some solar panels on them!

My Picks: ASTI, SPWRA, CPST, QTWW, ENOC, AONE, XIDE, BYD (BYDDF.PK on Yahoo).

Nov 13 10:37 AM

[Douglas Hvi...:]

It is useful to compare possible stock investments with "reality" investments. Examples: even an apartment dweller can grow a few plants in containers; someone in a small town can have a backyard garden; if you own your house, a solar hot water system pays off if well designed; etc. These "investments" may not return cash, but are totally inflation/deflation proof, and for some of them the primary requirement is a bit of labor.

Such comparison reduces my overconfidence. When a little figuring shows that increasing garden space by 5% reduces the need to buy food by more than our probable return in a stock, even figuring in the labor, I go with the garden. Ditto for the others.

Nov 13 10:55 AM

[Alan Young:]

Thanks for clarifying your strategy. The 20-30 year horizon you enjoy provides perspective. Those of us with shorter time frames will have to take that into account.

Nov 13 11:12 AM

[Thomas Smic...:]

"Is it the right thing to do" is not especially astute investment advice. Green investing is just another sector that will be subject to the vagaries of the market. Even moreso, green investing, being a recent managerie of disparate eclectic securities, will be the recipient, as are most sectors, of unintended cosequences such as protectionist regulations (GE is already complaining about that in their Asian market) government subsidies,litigation, and, God forbid, if the premise of green technology to save the planet is flawed.

There may well be a case made for a double short ETF in this sector if profits (the prime reason for investing) are to be made, short and long term.

That said, I enjoyed your article and appreciate your view.

Nov 13 11:37 AM

[jerrydd:]

Regretfully this author doesn't know much about actual technologies that will be the future.

For instance anything to do with H2 and Fuelcells should be avoided as they are not eff, using far more energy plus have short lives.

Ultra capacitors should also be avoided as they are too heavy, way too expensive and no capacity. Any 'battery ' company who says they are UC too as they are hold little power, doable in the same package. They work on completely different methods that can't work together.

We already buy cost effective Lithium batteries and no breakthroughs are needed, just orders. Most battery companies will fail because the market for them in any quantity is 4-5 yrs away.

If you want to invest in green I'd invest in Ford, Nissan as they are ready to massively ramp up EV's, PHEV's and high eff ICE's late next yr when gas becomes $5gal again.

FPL is a utility that has loads of RE in wind and solar and putting in more but down now because of the utility part of their business in Fla. But they have no where to go in both utility and RE but up nicely and pay dividends.

I'd invest in oil on the price drops, ladder in over the next 3 months as oil is going up with a bullet as the world economy recovers to do peak oil investing. But don't go too long as it will flatten out in 4-6 yrs, then drop as it gets replaced by other tech, eff/conservation. Nothing quite like $5-10/gal to get people to switch transport fuels/vehicles.

Don't invest in coal as it has dropped in use by 15% in the US and will drop more so very risky.

NG for utilities and trucks, semi's but that is a hard thing to play.

Making power from waste heat will be big but I don't see anyone really going after it. Just from our powerplants including nukes you can get 20% more electricity by putting geothermal equipment between the steam turbines and the condensers. GE, Ormat, others should be on this but are not. Watch for those that do and get on that bandwagon when it hits.

Be very careful betting on green as a lot of hype and little else is out there. Though the good ones will soar, most will die.

Nov 13 12:42 PM

[Tom Konrad:]

Douglas,
These are excellent points, especially for people who have money outside an IRA or other retirement account to invest.

If you do have money outside a retirement account to invest, and own, rather than rent a home, here is the hierarchy for using that money that I'd advocate:

1) Pay off any debt carrying an interest rate over 10% (credit card, etc)
2) High return energy efficiency investments such as attic insulation, caulking, CFLs, changing the filter on you furnace/AC, hot water heater blankets, ...
3) Maybe a garden if you also have the necessary time to invest.
4) Pay off other debt, including your mortgage.
5) Lower return energy efficiency investments, such as upgraded appliances, furnace, water heater, solar hot water, solar PV (IF you are in a state with good incentives.)
6) Green energy stocks or funds.

On Nov 13 10:55 AM Douglas Hvistendahl wrote:

> It is useful to compare possible stock investments with "reality"
> investments. Examples: even an apartment dweller can grow a few plants
> in containers; someone in a small town can have a backyard garden;
> if you own your house, a solar hot water system pays off if well
> designed; etc. These "investments" may not return cash, but are totally
> inflation/deflation proof, and for some of them the primary requirement
> is a bit of labor.
>
> Such comparison reduces my overconfidence. When a little figuring
> shows that increasing garden space by 5% reduces the need to buy
> food by more than our probable return in a stock, even figuring in
> the labor, I go with the garden. Ditto for the others.

Nov 13 01:06 PM

[Tom Konrad:]

Thomas,
I suspect that your complaint that is really that you *don't* believe that investing in green energy is the right thing to do, not that it should not be part of an investment allocation strategy. Do you also believe that planned donations to charity (because they are the "right thing to do") should not be considered as part of investing strategy? If so, your attitude conflicts with the approach to asset allocation I studied as part of the Chartered Financial Analyst(R) curriculum.

I see an investment in Green Energy because "it is the right thing to do" as part investment and part donation to charity, and hence believe they should be included in any asset allocation plan where the belief exists.


On Nov 13 11:37 AM Thomas Smicklas wrote:

> "Is it the right thing to do" is not especially astute investment
> advice. Green investing is just another sector that will be subject
> to the vagaries of the market. Even moreso, green investing, being
> a recent managerie of disparate eclectic securities, will be the
> recipient, as are most sectors, of unintended cosequences such as
> protectionist regulations (GE is already complaining about that in
> their Asian market) government subsidies,litigation, and, God forbid,
> if the premise of green technology to save the planet is flawed.
>
>
> There may well be a case made for a double short ETF in this sector
> if profits (the prime reason for investing) are to be made, short
> and long term.
>
> That said, I enjoyed your article and appreciate your view.

Nov 13 01:17 PM

[Tom Konrad:]

<img class="authors_reply" src="static.seekingalpha.co...">

On Nov 13 12:42 PM jerrydd wrote:
> Regretfully this author doesn't know much about actual technologies

Jerry,
We disagree about the economics of green technology, and that is part of investing. Disagreements between investors are the source of one investor's ability to beat the market, and also the source of other investors' underperfomrance.

Your assertion that I'm wrong is worthy of consideration by all readers.

In contrast, your assertion that I'm uninformed is rather humorous. Anyone wishing to test this latter assertion should visit my website, AltEnergyStocks.com, and read a few of the hundreds of articles I've written over the last 3+ years.

Nov 13 01:35 PM

[Zenfar:]

Tom your mention of paying off debt along with going green earns you a +100 in my book.

Nov 13 01:42 PM

[Thomas Smic...:]

Donations are investing? Promoting religious,political or social agendas under the banner of investing is an interesting concept. I do own a few green technology stocks within my portfolio - but they are owned to increase the value of the portfolio, not to be confused with donations or ideology strategies which should never be touted to investors as such. For the truly rich, CFAs will use giving (donating) as a tax strategy - to avoid contributing what I believe many view as their fair share of taxes. How noble. That is the essence of a substantial part of the CFA curriculum of which you speak.

On Nov 13 01:17 PM Tom Konrad wrote:

> Thomas,
> I suspect that your complaint that is really that you *don't* believe
> that investing in green energy is the right thing to do, not that
> it should not be part of an investment allocation strategy. Do you
> also believe that planned donations to charity (because they are
> the "right thing to do") should not be considered as part of investing
> strategy? If so, your attitude conflicts with the approach to asset
> allocation I studied as part of the Chartered Financial Analyst(R)
> curriculum.
>
> I see an investment in Green Energy because "it is the right thing
> to do" as part investment and part donation to charity, and hence
> believe they should be included in any asset allocation plan where
> the belief exists.

Nov 13 03:32 PM

[Tom Konrad:]

The role of charitable donations in financial planning is two-fold. First, tax planning as you suggest (although since the tax saving is always smaller than the donation, it still requires some altruism.)
Second, planned donations should also be considered as a liquidity requirement. If you're planning to donate $1000 a year to your church from your savings, you should make sure that your have sufficient liquidity to cover this.

Regarding your first point, no matter how much you protest, your investment action has knock-on effects in the real world. Charity is money set to moral causes, rather than financial ones.

There is a large school of thought (to which you seem to belong) that all profit-maximizing behavior is good (in short, "Greed is Good.") This school of thought is, in essence, logically incompatible with charity (which is probably why you assume that everyone who donates to charity is motivated solely by tax planning.

I happen to disagree that profit maximization is always good, even when it is legal.

Most of what went on that led to the financial crisis was both profit-maximizing, and legal. However, taken as a whole, it caused harm to our economy. Many large financial institutions were legally taking very large risks with what turned out to be taxpayer money. To the extent that they were aware that others would be bearing that risk, their actions were immoral, and now that society recognizes the problems they created, taking such risks with public money for private profit should also be made illegal.

If we invest in companies that are engaging in acts we see as immoral, we are supporting those acts by helping those companies obtain funding. Would you loan money to a man who wanted to use it to buy a gun to kill people?

Since you are a Christian, you must have morals. Why do you insist that your investments should not have morals? What would Jesus invest in?


On Nov 13 03:32 PM Thomas Smicklas wrote:

> Donations are investing? Promoting religious,political or social
> agendas under the banner of investing is an interesting concept.
> I do own a few green technology stocks within my portfolio - but
> they are owned to increase the value of the portfolio, not to be
> confused with donations or ideology strategies which should never
> be touted to investors as such. For the truly rich, CFAs will use
> giving (donating) as a tax strategy - to avoid contributing what
> I believe many view as their fair share of taxes. How noble. That
> is the essence of a substantial part of the CFA curriculum of which
> you speak.
>
> On Nov 13 01:17 PM Tom Konrad wrote:

Nov 13 04:53 PM

[Emeka:]

I watched CNBC last night, they had Warren Buffet and Bill Gates on, they were both at Columbia University. Both men discussed the future of the United States and both are very optimistic for various reasons.

In relation to the future, they both stressed the importance of and opportunities in the energy & health care space. The U.S. has the capacity and energy to lead the way in these two areas. I happen to work in the Biotechnology area and I have had the privileged of working with some extremely fine scientists. They are not only smart but also very creative and dynamic and this is truly a unique feature in the U.S. I am not aware of any other country in the world that has the level of openness and opportunities as you find in the U.S.

Green energy is another area that will be developed and will flourish. Anyone who is a doubting Thomas will end up missing the boat on this one. Yes, many companies will fail along the way, but this is not new. All you have to do is look at the Biotech or Technology space. Many Googles, Ebays, Apples, Amgens, Genentechs etc failed, but the listed companies made it and they made it big. Those who saw the opportunity and took advantage, made out very well. Investing has a lot to do with insight and a unique way of looking at things. Foresight is critical and patience is truly a virtue.

Warren Buffet always stresses the importance of planning for the long run i.e choose a company that has a product or service that you believe in and that you can envision being around for the long haul. For this reason, I support Tom's view of things, green technology will work and the U.S. will play a significant role in this space.

Nov 13 09:04 PM

[Will Deliver:]

I respect and agree with both Doug H & Jerrydd. Growing a garden is a great comparison to investing in a 'green' portfolio. I believe that in addition to investing in 'green stocks', I think we should all actually buy a product from our favorite category. IE: Buy some LED lights, install a rooftop photovoltaic system, learn how to build your own solar hot water heater & build it! Like Jerrydd said, battery companies need orders to succeed. So do all of the other green companies. Let's show our support to our green companies and spend some money! Thanks, Will.

Nov 16 01:00 PM