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M. Todd Henderson Headshot

Divestment and Financial Illiteracy

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The state of financial literacy in America is rotten. A Dodd-Frank-Act-mandated study of financial literacy recently concluded: "investors have a weak grasp of elementary financial concepts." Or, consider the 2009 National Financial Capability Study finding that only 52 percent of investors understand owning a broad basket of stocks provides a safer return than investing in a single company stock. This is like saying 52 percent of people believe in gravity.

The divestment wave hitting college campuses looks like another example of financial ignorance. Students for a Just and Sustainable Future (SJSF) is pressuring universities across the nation to force their endowment funds to divest their investments in fossil fuel companies. Students at Swarthmore, for instance, recently shouted down dissenting voices at a campus meeting on the subject, where Swarthmore's investment manager was describing the expected costs ($200 million over 10 years) of divestment. The students' tactic seems to be trying to put pressure on the stock price of fossil fuel companies, and therefore force the firms to change their behavior. Unfortunately for SJSF, there is little evidence to suggest this is likely to work.

A central tenet of corporate finance is that demand curves for individual stocks are approximately horizontal. For most things we buy, demand curves slope downward. This means if we demand less, less will be supplied and at lower prices. But stocks are not like other products. The stock price is merely an estimate of the cash flows that ownership of the stock will produce in the future, and therefore is not determined by a "demand" for the stock. Unless the sale of stock conveys information to the market about the future cash flows, no individual sale can move the price.

If the Harvard Management Company, which invests Harvard's more than $30 billion endowment, sells all of the shares it owns in ExxonMobil, the stock price of ExxonMobil should not change. Others will stand ready to buy the shares at the current market price, meaning supply and demand aren't helpful ways to think about stock prices. Unless the money that ExxonMobil is expected to earn in the future goes down, the stock price will stay the same. And nothing about the decision of a few university endowments to sell the shares provides the market information about how much oil or coal will be sold at what prices tomorrow. This is true even if SJSF succeeds in getting every university to sell all their shares.

Some economists claim certain demand shifts for stocks -- e.g., by removing a stock from an index -- can impact stock prices. But even full divestment by all universities wouldn't likely have the same impact as removal from a stock index. Moreover, any effect is likely to be small and not persist over the long run. Undervalued shares in the near term will be bought up until their price more or less reflects the expected gain from holding those shares. In the extreme, ExxonMobil could simply go private, removing any need to rely on public markets for funding or valuation.

The fact that the stock price of divested companies will not fall means that these firms will not experience a higher cost of capital, and therefore nothing about their capital raising activities, project choice, or other decisions will be effected by divestment. Managers with stock-based compensation won't be affected either. Nor will other shareholders of these firms. In short, the economic impact of the SJSF demands on the targets of their ire would be nearly zero.

Making matters worse, universities, or rather their employees and students, will bear large costs to achieve no benefits. The endowments already are having to spend money defending their investment decisions, and, if it comes to it, will spend more selling shares and accepting lower returns than would otherwise have available. Taking profitable investments off the table also means lower returns for endowments. This means taking money out of the universities' pockets and putting it into the hands of other people, all without actually imposing any cost on the alleged bad actors.

SJSF might argue that their campaign is about raising the public awareness of the problem of carbon emissions and fossil fuels. If this is their goal, there are far better ways to proceed. For instance, getting universities to use energy more efficiently, to source their energy from more renewable sources, or to change students' energy usage. Not only would these strategies potentially reduce the use of fossil fuels, they would not put the costs onto others, namely future students who will pay more to attend colleges made poorer by bad investment decisions of their schools.

Perhaps the real lesson of the divestment wave building on American campuses today is that colleges should devote more time to teaching economics and elementary finance to their students. Armed with some basics, these well-meaning students would be able to make a much bigger impact on our world.