How Climate Disasters Impact Investment Decisions

Money Managers in Hurricane Zones Dump Regional Stocks

Dec 11, 2020
Finance
As Featured In 
Review of Financial Studies

Living through a climate-related disaster can be a harrowing experience for anyone. For professional money managers, it can even impact their investment decisions, according to recent research from the Center for Financial Policy (CFP) at the University of Maryland’s Robert H. Smith School of Business.

Maryland Smith finance professor Russ Wermers, director of the CFP, worked with Shashwat Alok and Nitin Kumar (formerly a Smith PhD student in finance) of the Indian School of Business on the research, published in the Review of Financial Studies. They looked at whether professional money managers overreact to large climate disasters.

The researchers specifically looked at the effect of hurricanes on equity fund managers’ portfolio allocations and what happens when the hurricane hits in the region where the manager lives.

“So if you’re a fund manager in New York and a hurricane hits the city – think Superstorm Sandy, that pummeled the region in 2012 – does it affect your holdings? Do you scale back on New York-based stocks or not?,” says Wermers.

They did scale back in a big way, says Wermers – a costly blow for investors. His findings reveal that money managers tend to overly exit stocks in a hurricane zone if the portfolio manager was also personally in the hurricane zone.

The findings hold true for any climate-related disaster – hurricanes, wildfires, blizzards.

“Being close to a natural disaster or a disaster of some type changes the behavior of a professional money manager,” says Wermers. “Professional managers actually oversell the stocks that are in the hurricane zone if they personally are also located in the hurricane zone.”

Money managers in disaster zones are overly impacted by what is called salience bias, says Wermers, which means that they are impacted by experiencing the hurricane or other natural disaster firsthand.

“To some extent, they panic and exit these stocks in a big way,” says Wermers. “This hurts their performance going forward because their sales are at fire-sale prices and the stocks bounce back.”

Wermers says the results surprised the researchers.

“We thought they’d be immune to these types of things, unlike individual investors who are likely to be very impacted by things that we see happening in our local area,” he says. “It was surprising that professional managers also exhibit that behavior.”

As climate change brings more extreme weather – worse wildfires, stronger hurricanes – this effect could happen more often and have real impact in financial markets, says Wermers.

“More of these climate change-related disaster events could push professional managers to do more of these fire-sale types of things – no pun intended – and this may increase the volatility of stocks.”

Read the full research, “Do Fund Managers Misestimate Climatic Disaster Risk?,” in the Review of Financial Studies.

 

About the Author(s)

Russell Wermers

Russ Wermers is Professor of Finance at the Smith School of Business, University of Maryland at College Park, where he won a campus-wide teaching award during 2005 and a Krowe Teaching Award (within the Smith Business School) during 2013. His main research interests include studies of the efficiency of securities markets, as well as the role of institutional investors in setting stock prices. In addition, he studies and teaches quantitative equity strategies, and is currently researching microfinance institutions in Thailand. Most notably, his past research has developed new approaches to measuring and attributing the performance of mutual funds, pension funds, and hedge funds, as well as devising winning strategies for investing in these funds.

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