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DIY Values-Based Investing

Defining Your Investment Values: A Practical Process

Pomegra Learn

How Do You Define Your Investment Values?

The most important step in values-based investing is one that most guides skip: clarifying what you actually value before selecting any investment product. This sounds obvious — but the majority of individual investors who want "ethical" or "ESG" portfolios have not thought carefully about what that means to them specifically. "ESG" in practice can mean anything from excluding tobacco to overweighting companies with gender-diverse boards to funding clean energy infrastructure. Without personal values clarity, "sustainable investing" is whatever the product provider defines it to be — which may or may not reflect your actual values. This article guides individual investors through a practical values clarification process: identifying non-negotiable exclusions, establishing positive themes worth supporting, understanding the trade-offs between different values criteria, and translating values into portfolio criteria that can actually be implemented.

Investment values clarification is the process of identifying which specific industries, activities, or company behaviors are non-negotiable exclusions from your portfolio, which positive themes you want to support, and how you prioritize these criteria when they conflict — creating a personal investment policy that guides fund selection and portfolio construction.

Key Takeaways​

  • Non-negotiable exclusions (industries or activities you will not profit from under any circumstances) should be identified first — they are the hardest constraints that define your investable universe.
  • Positive themes (industries or activities you actively want to support) are preferences, not exclusions — they guide overweighting decisions but don't require complete alignment.
  • Values often conflict: labor rights and fossil fuel exclusion conflict for workers' pension funds; animal welfare and global food company exclusion conflict with emerging market access; military exclusion and national defense conflict for many values frameworks.
  • The cost of values varies by how many companies you exclude — broad exclusions (all fossil fuels, all weapons, all animal agriculture) create significant tracking error and potential return costs; narrow exclusions (only tobacco) are nearly costless.
  • A written personal investment policy statement — even one paragraph — significantly improves the quality of fund selection decisions and prevents values drift over time.

The Values Clarification Process​

Step 1: Identify Your Non-Negotiables

Non-negotiable exclusions are industries or activities that you would not invest in at any expected return — they are moral bright lines, not financial trade-offs. Common categories:

Weapons and defense:

  • All military weapons manufacturers? (This would exclude large defense contractors — Lockheed Martin, Raytheon, Boeing's defense division)
  • Controversial weapons only? (Cluster munitions, landmines, biological weapons — which are excluded by many ESG funds as a baseline)
  • Civilian firearms manufacturers? (Smith & Wesson, Sturm Ruger)
  • Nuclear weapons? (Involves many technology companies with nuclear applications)

Fossil fuels:

  • All fossil fuel producers? (Coal mining, oil and gas extraction)
  • Fossil fuel utilities? (Coal-fired power generators)
  • Fossil fuel financing? (Banks with significant fossil fuel lending)
  • All energy infrastructure? (Pipelines, LNG terminals)
  • Natural gas included or excluded? (Transition fuel argument vs. full exclusion)

Tobacco:

  • Tobacco producers? (Standard exclusion in most ESG funds)
  • Tobacco distributors? (Less commonly excluded)
  • Companies that derive minor revenue from tobacco products? (Where is the line?)

Other common exclusion categories:

  • Gambling (casinos, online gambling platforms, sports betting)
  • Alcohol (brewers, distillers, alcohol retailers)
  • Adult entertainment
  • Private prisons (including private detention centers)
  • Predatory lending
  • Animal testing (pharmaceutical testing? Cosmetics testing only?)

Step 2: Identify Positive Themes

Positive themes guide what you actively want in your portfolio. These are preferences, not hard requirements:

Environmental themes:

  • Renewable energy
  • Clean water and water efficiency
  • Sustainable forestry and land management
  • Circular economy and waste reduction
  • Sustainable agriculture

Social themes:

  • Gender diversity and equality
  • Community development and affordable housing
  • Living wage employers
  • Education technology
  • Healthcare access

Governance themes:

  • Strong board independence
  • Transparent executive pay
  • High shareholder rights protection

Step 3: Identify Values Conflicts

Before finalizing your criteria, consider how they interact:

Common conflicts:

  • Excluding fossil fuels entirely also excludes many utilities that are actively transitioning to renewables but currently derive revenue from natural gas
  • Excluding all defense contractors also excludes aerospace companies with significant civilian applications
  • Excluding all animal agriculture also excludes many food companies that are diversifying toward plant-based alternatives
  • Excluding banks that finance fossil fuels also significantly limits banking sector exposure

Common Exclusion Categories and Their Portfolio Impact​

Tobacco exclusion:

  • S&P 500 tobacco sector weight: approximately 0.2-0.4%
  • Tracking error impact: minimal (0.1-0.2% annual tracking error)
  • Cost impact: near-zero
  • This is nearly the cheapest possible exclusion — widely implemented in ESG funds as a baseline.

Weapons (controversial weapons only):

  • Cluster munitions, landmines, biological/chemical weapons: extremely small market cap
  • Tracking error: near-zero
  • This exclusion is nearly universal in European ESG funds and legally required by some pension fund mandates.

Fossil fuel producers (full):

  • S&P 500 energy sector weight: approximately 4-6% (highly variable by year)
  • MSCI World energy sector weight: approximately 4-5%
  • Tracking error impact: 0.5-1.5% annual tracking error vs. parent index
  • Return impact: highly variable — 2022 energy sector returned +65.7%; 2020 returned -37%. Exclusion cost is enormous in energy bull years.

Fossil fuels + utilities (full):

  • Combined S&P 500 weight: approximately 7-10%
  • Tracking error: 1.5-2.5% annual
  • Significant return impact in energy bull markets.

All weapons (including defense contractors):

  • S&P 500 defense sector weight: approximately 1-2%
  • Tracking error: 0.3-0.5%
  • Moderate impact — some large defense companies also have civilian divisions.

Animal agriculture:

  • Consumer staples and consumer discretionary food sectors
  • Complex to implement — most food companies have some animal products
  • Significant coverage limitation for global equity portfolios

Revenue Thresholds: Where to Draw the Line​

For many exclusion categories, companies derive some revenue from the excluded activity but are primarily in other businesses. Revenue thresholds determine where you draw the line:

Common threshold conventions:

  • MSCI/Sustainalytics: Often uses 5% and 15% thresholds (exclude if >5% or >15% revenue from specified activity)
  • Some ESG funds: 0% threshold (exclude any meaningful revenue from the activity)
  • Other funds: 50% threshold (only exclude companies whose primary business is the activity)

Example — fossil fuels:

  • Apple, Google, Microsoft: 0% fossil fuel revenue → include at all threshold levels
  • An industrial company with 3% fossil fuel subsidiary revenue → exclude at 0% threshold, include at 5%+ threshold
  • Exxon, Chevron: 100% fossil fuel revenue → exclude at all threshold levels
  • A utility company with 30% natural gas generation → exclude at 0% and 15% thresholds, include at 50% threshold

Choosing your threshold: The right threshold reflects your personal values logic:

  • If you want to avoid any financial benefit from the excluded activity: 0% threshold (very restrictive)
  • If you want to avoid companies whose primary purpose is the excluded activity: 50% threshold (permissive)
  • If you want to avoid significant exposure while allowing minor incidental revenue: 5-15% threshold (standard ESG fund approach)

Translating Values Into a Personal Investment Policy Statement​

A personal investment policy statement for values-based investing doesn't need to be formal — even a few sentences clarifies your thinking and guides decisions:

Example IPS (simple): "I will not invest in companies that produce tobacco products or cluster munitions. I want my portfolio to underweight fossil fuel producers and overweight renewable energy companies. I am comfortable with up to 1% annual tracking error vs. a broad market index. I am not willing to pay more than 0.25% in additional management fees for ESG implementation."

Example IPS (more specific): "Exclusions: (1) tobacco producers (any revenue); (2) manufacturers of cluster munitions, landmines, or biological weapons; (3) companies with >15% revenue from thermal coal mining or coal-fired power generation; (4) private prison operators. Positive preferences: renewable energy exposure, companies with >30% women on their boards, CDFI community banks. Cost tolerance: up to 0.20% additional ETF expense ratio and up to 1.5% annual tracking error vs. MSCI World."

When Your Values Conflict with Diversification​

Some values criteria are broad enough to significantly limit diversification:

Energy sector exclusion: Excluding all fossil fuels removes 4-6% of market cap from developed market portfolios. In energy bull markets (2022), this creates significant underperformance.

Banking sector exclusion: If you exclude banks that finance fossil fuels, you may exclude most of the financial sector — since most large banks have some fossil fuel lending.

Resolution strategies:

  • Accept the tracking error as the honest cost of values alignment
  • Implement partial exclusions (only the most harmful activities at high revenue thresholds)
  • Use engagement-focused strategies where possible rather than full exclusion

Common Mistakes​

Trying to exclude everything negative. Some investors want to exclude all companies with any negative ESG characteristic — which produces an empty investable universe. Define your priorities. Every company has some problems.

Not specifying revenue thresholds. "No fossil fuels" without specifying what counts as fossil fuel exposure will frustrate you when you discover your fund holds companies with small fossil fuel subsidiaries. Specify thresholds when writing your investment policy.

Changing values criteria frequently. Frequent changes to exclusion criteria create unnecessary transaction costs and prevent consistent strategy implementation. Set criteria thoughtfully and review annually, not in response to news events.

Summary​

Values clarification before fund selection is the essential first step in DIY values-based investing. The process: identify non-negotiable exclusions (moral bright lines, not financial trade-offs), establish positive themes (active preferences for overweighting), assess conflicts between different values criteria, determine revenue thresholds for borderline cases, and document conclusions in a brief personal investment policy statement. Common exclusion categories have different portfolio impacts — tobacco exclusion is nearly costless; fossil fuel exclusion creates 0.5-1.5% tracking error with significant return impact in energy bull years; controversial weapons exclusion is minimal. Revenue thresholds (0%, 5%, 15%, 50%) determine whether companies with minor incidental revenue from excluded activities are included — matching the threshold to your values logic produces a more coherent exclusion policy. A written personal IPS improves the quality of subsequent fund selection decisions and prevents values drift over time.

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