Tuesday, April 7, 1998


To the Editor:

Recent attempts to relate Yale's investments in various stocks to ethical behavior belay a lack of understanding of equity markets. Recent articles and letters argue that Yale should not invest in stocks of companies that engage in ethically questionable activities (e.g., tobacco firms) and that even to profit from such a company without actually owning equity in it (as was done by shorting Exxon) is to confront an “ethical dilemma.” This is nonsense.

A share of stock in a company represents some fraction of ownership in it. However, for purposes of investment and speculation, this relationship with the underlying company is often tenuous, especially in the case of companies like Philip Morris or Exxon whose market capitalizations (the value of all stock issued) each exceed $100 billion. Note that even if Yale put all its money into a 6 percent share of Philip Morris, it wouldn't exert much influence. Those who cry “unethical investment” know this. That is why they avoid the obvious suggestion that we use Yale's substantial financial weight to enforce ethics by buying majority shares of unethical companies and halting their unethical practices. An investor typically buys stock because he believes he has superior information to the market and can therefore generate a profit.

The price of a stock is a function of numerous factors, the biggest of which are the company's assets and the projected performance of the company. However, while these two are relatively easy to gauge, most other factors are not generally available or clear. The market price of a stock is a sort of consensus estimate of what it is worth, taking into account all possible factors. But if someone comes along with better information than the market, he can profit from this “market inefficiency” by buying while the market has underestimated the value of a stock and selling while it is too expensive. In other words, market pays people who increase its efficiency, and it is this wage — not the profit of unethical businesses — that investors seek.

Let's try to bring out the role of ethics by looking at two extreme situations: efficient markets, and ethical markets. In an efficient market investors like the one described above would not exist. You couldn't beat the market, and since stocks would be priced only by risk you could easily construct a desired portfolio while ignoring a large number of individual, “unethical” stocks.

Now, consider what would happen if one morning everyone woke up an ethical investor. If everyone in the world decided not to own the stock of Exxon, for example, its market value would indeed go to zero. However, the stock would still be worth around $70 a share. This is because the company would still have $50 billion in assets and generate $140 billion in revenue next year. Whoever was left owning the stock might be upset at not being able to sell their shares at fair value, but next year's estimated $10 billion in profits would still be all theirs. The company would go on doing business as if nothing had happened.

The schism between the market and the business becomes even more clear when other methods of investment are considered.

If buying and selling stocks directly is unethical, long and short positions in a stock can be simulated (albeit at higher costs) using options, which can be traded to a profit without ever owning the underlying stock. It is humorous to try to introduce the ethics of the underlying company into such transactions.

The profits are there to be had, even if Yale has underperformed the market by a factor of two over the past decade.

The only way to legislate ethics is on the business side — if you make unethical behavior unprofitable, unethical businesses will not prosper. If you try to impose ethics on the market, the businesses effecting the unethical behavior will be unaffected, and “ethical” investors will miss opportunities that the rest of the market will seize.

David Bookstaber '99

April 1, 1998

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