I have argued here that ESG investing has crossed a tipping point where it has become mainstream and is difficult to reverse. But this tipping point has not been universally reached. In the United States, ESG investing is much smaller and growing at a slower pace than in Europe. So where are these tipping points that change an industry?
Many people have read Malcolm Gladwell’s “Tipping Point” and full disclosure, I have not. So, forgive me if I use different definitions and descriptions than he does. In my understanding, a tipping point is a phenomenon where – in the parlance of a physicist – you experience a phase transition. You have a group of investors who believe that asset X (for example a stock) is cheap and should be worth more. Meanwhile, you have another group of investors who hold the asset and think it is not worth as much or who are outright bearish on it and ready to sell. And then there is the large group of investors who are more or less indifferent about it and won’t get involved for now.
But we humans are social animals and if we know someone who likes asset X, we are more likely to get interested in it as well. And if the story is good, we may catch the bug and buy that asset as well. Hence, what can happen is that if there is a critical mass of people who believe in asset X these social networking effects create exponentially fast growth in investors which very quickly overwhelms the number of investors willing to sell the asset. Hence, you get a sudden tipping point, when the balance between demand and supply shifts very rapidly and the price explodes.
The question is, what conditions need to be met for such a tipping point to exist? How large (or small) does the group of bullish investors have to be to create this rapid increase in prices? This is the question that Damon Centola and his colleagues set out to answer.
They created different experiments where volunteers were asked to agree on a naming convention for images and were financially incentivised to find that consensus. Then the experimenters introduced a group of confederates that tried to change this consensus and get the group to adopt a different one. To make a long story short the tipping point was reached when the confederates reached a critical mass of some 25% of the group. If the group trying to change consensus was less than one in four, the efforts would fizzle out.
This result has implications for all kinds of effects. For example, if women in corporate leadership roles exceed 25% of corporate leaders in a company, the behaviour of the leadership teams changes, and the benefits of gender diversity are felt in the company. This is what we find in our research as well and what is reflected in regulatory approaches to diversity and inclusion. We find that once more than 30% of directors of a company are women, the profitability and risk taking of a company changes significantly for the better.
Similarly, if more than 25% of investors insist on including ESG criteria in their investment process a critical mass is reached that forces the asset management industry to offer a wide range of ESG products. The rapid increase in ESG investing across Europe may simply reflect the fact that in Europe, the critical mass of interested investors has been reached, while in the United States it has not. Once enough US investors get into ESG investing, the trend there is likely to explode similarly to Europe.
But the tipping point works the other way around as well. Every change in consensus creates a reaction from people who are unwilling to change or who think the change has made things worse. This group of people then coalesces to become a minority to change the new consensus. Once this group reaches the necessary critical mass of 25%, they can move the consensus once again. The only conditions that must be met are that there is this critical mass of 25% plus that the people in this critical mass are committed to change and keep on pushing for change.
And this gives us a completely new way to interpret surveys. We know for example that in Europe some 40% of all assets are managed with some sort of ESG overlay, so the critical mass has been surpassed and ESG has taken off. Meanwhile, the people who are committed to sin stock investing are a small minority and are unlikely to shift the consensus away from the ESG investing trend. But it is worth surveying investors and asset managers about their opinions on ESG investing, diversity, etc. to get an early signal of when the tides may turn.
Similarly in politics (not that I want to become too political here since this is an investment post), if you have a committed minority of the population that reaches the critical mass about a certain subject (e.g. taxes or regulation) this subject suddenly becomes a legitimate political theme that can make it into law. It doesn’t matter whether that subject is a good or bad policy. All that matters is that you have a sufficiently committed group that thinks the policy is good and should be implemented.
This is a good article because it helps us see a more general situation. The 25% idea is sound and generally observable. The problem that arises is that the 25% are motivated and impatient. Most have an agenda that deals with some aspect of a bigger situation. ESG, as an example, solves nothing and is immeasurable. It does produce a cost for businesses though. Perhaps clarifying what we want businesses to do would help. They cannot be everything to everyone.
Motivated people tend to want an immediate answer while the more thoughtful tend to be willing to evolve answers. Most of the things that work in our societies tend to have evolved. Certainly, the role of women has changed over the decades.
Motivated answers tend to be too costly while evolved ones use tools and techniques that come available in the future. People tend to always get slow moving problems figured out before catastrophe occurs. Patience is usually wiser and less expensive.
Activists are always impatient because they think urgency drives action. As one client explained decades ago. "I don't need to be first. I need to be the first to right." The first to be right is a patient goal, and it always works for the better.
I think the way to bet today is wokeness will disappear and ESG with it. All that we will have then are steps that are directionally accurate and adjustable. We'll evolve someting that works better. Optimal is a useful goal; perfect is not.
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