Financial Bubbles and ESG Investments

With the UN Climate Change Conference (COP26) drawing to a close tomorrow, it seems fitting to focus on climate-minded investments

The world has grown more aware of the impact humans have on the environment. As a result of this, nations around the world have come together in Glasgow to discuss plans for how to achieve a low-carbon future. Because businesses are now coming up with clever green solutions, we are consistently seeing an increase in ESG (environmental, social, and governance) funds. However, any time a fund sees a sharp rise in popularity, there is always the possibility of this creating financial bubbles.

What are financial bubbles?

Sometimes referred to as an economic or asset bubble, a financial bubble is the economic cycle of a stock or financial asset whose market value rapidly escalates and exceeds its value. This can also happen with entire sectors, markets, and asset classes. When the value of something becomes far greater than its intrinsic worth, this leads to price inflations.

Once the bubble has formed, it does what bubbles always do. It pops. The popping of financial bubbles results in large-scale selloffs and ultimately, the sharp decline of prices.

Stages of a financial bubble

Economists have long studied the patterns in which financial bubbles form and ultimately burst. While there are always exceptions to the rule, it usually goes as follows.

First, a displacement will occur. This is when something (e.g., a new piece of technology) becomes incredibly popular and attracts the eyes of investors. This is often shaped by society’s evolving culture.  

Next, the price of this new paradigm will slowly rise. As more people enter the market, the price will gain momentum and continue moving upwards. Then, as the fear of missing out looms over investors, more will get involved to get their piece of the pie.

The skyrocketing of prices then causes a feeling of euphoria amongst investors. However, over time, valuations begin reaching excessive levels. At this point, the bubble is just on the cusp of popping. This is typically when people start to become a bit fearful and consider pulling their investment.

Finally, when the bubble breaks, investors panic and liquidate. Prices then descend at a rapid rate.

A recent example of a financial bubble would be the Gamestop craze, which you can read up on in an article we wrote in September.

Will ESG funds create financial bubbles?

Green technology, renewable energy, and sustainable goods and services are becoming increasingly popular. It is an industry that some are saying will be worth trillions by 2030. Due to this growing popularity, many companies are therefore adopting greener business models and making the details of their policies publicly available.

COP26 is further creating a culture of transparency when it comes to green policies. The UK, for example, is aiming for net zero carbon emissions by 2050. By 2023, British firms will need to provide the public with plans for how they will become low-carbon institutions.

Some people in the industry are beginning to warn about ESG bubbles, saying that the demand will surpass the supply. Others argue that the ESG framework will continue to choose successful stocks as governments around the world are enacting policies to combat climate change. Proponents of ESG point to renewable energy companies, like Tesla, becoming more attractive to investors than fossil fuel companies, like Exxon.

The important thing to remember is that where there is demand, companies will appear to meet the supply. When it became public knowledge that cars emit an immense amount of pollution, companies manufactured clean energy automobiles. When the fast fashion industry was exposed for its unfair working conditions and unsustainable production methods, sustainable and ethical clothing companies like Everlane emerged. This will continue to happen, and in 5, 10, or 20 years, today’s leaders in the industry will have far more competition. After all, Jeff Bezos had to start somewhere. Amazon wasn’t always a billion-pound corporation.

It is wise to have a keen eye on the markets. Keep a lookout for up-and-coming businesses. Even if you choose not to invest in them, it is vital to understand which companies are competitors of one another. Additionally, knowing how much competition exists and at what rate new competitors are emerging will allow you to make more informed decisions.

How can you make the right choices for your investments?

There is no denying that ESG can provide great investing opportunities. Diversifying your portfolio in this way has the potential to produce returns. And of course, an ESG framework is not only good for investors. Evidently, it is also good for the planet. Therefore, we will always encourage investing in funds that will have a neutral or positive impact on the world.

That being said, it is still important to be aware of bubbles and follow the guidance of a qualified adviser. Following trends can be appealing, but it is imperative to get professional advice before making any big financial decisions. As financial advisers, we know how crucial it is to understand all the risks associated with investing. Studying the markets and watching them closely is essential, but it is not always enough if you do not have an expert helping you.

To ensure that you make the most of your ESG investments, schedule a free consultation with one of our Wealth Managers today.

If you would like to learn more about our approach to sustainable investing, you can read our statement here.