Despite the rapid growth of interest among individual investors in sustainable investing and the corresponding growth in sustainably invested assets, an astounding 63% of advisors have expressed little interest in the field (Hale 2015—see footnotes below for all citations). This “disconnect” between advisors and investors recently discussed in an article (Green 2015) is puzzling.
One answer to this puzzle can be found in how advisors, and other industry professionals, differ from clients in how they evaluate investment returns and investing’s other psychological impacts (e.g., Jansson and Biel 2011, Paetzold et al., 2015). With a better understanding of the psychology of sustainable investing, advisors can fix this disconnect: to the benefit for their practices and their clients.
Facing the Frontier, and Beyond
Advisors are trained to look for the efficient frontier – optimizing client returns for a selected level of risk (or vice versa). It’s the sensible, responsible approach to serving clients. Yet many advisors appear to misjudge the impact that sustainable investing actually has on returns, and, more subtly, many overestimate the importance of returns to their clients (e.g,. Jansson and Biel 2011, Paetzold et al. 2015).
Researcher and author Meir Statman provides a simple framework for thinking about the psychology of investing in his book, “What Investors Really Want” (2011). “We want more from our investments than a reasonable balance between risk and return….Investments offer three kinds of benefits: utilitarian, expressive, and emotional.”
Using Statman’s framework, let’s see what each of these could mean for sustainable investing and the odd disconnect between advisors and their clients.
Investments offer a clear utilitarian benefit for their owners: returns. In terms of sustainable investing, there’s still no consensus view on whether sustainable options deliver similar or better long-term returns relative to other investment options. However, the long-held assumption among advisors and others that sustainable investing would undermine performance appears to be false.
- Sustainability factors (environmental, social, and governance practices) appear to improve corporate financial performance (e.g. Morgan Stanley 2015; Friede et al. 2015) – which may or may not translate into investor returns.
- There’s evidence of a historical bump in returns for investors who previously selected companies based on sustainability factors (Morgan Stanley 2015; Clark et al. 2014); though not necessarily for SRI practices excluding “sin stocks” (Derwall et al. 2011).
- Overall, indexes of sustainable funds appear to have similar performance to non-sustainable benchmarks (Prior 2014).
In terms of the psychology of investing and performance, it’s important to remember that sustainable investing is subject to the same cognitive biases as any other form of investing. In particular, we’re hardwired to be overconfident about our ability to outsmart others.
Thoughtful, careful advisors can use sustainability information as part of a broader suite of information to drive performance for their clients, remembering that both they and their clients should be realistic about what is feasible in the market. With respect to returns, data about sustainable practices is another tool in the toolbox, and the whole toolbox must be used judiciously.
In addition to generating returns, one’s investments also have a very different role: they express our values, our tastes and our status to others. Clearly, for some people, sustainable investing expresses their values to the world: they are proud to invest in companies and funds that engage in positive environment, social or corporate governance practices.
Some advisors see this expressive motivation and dismiss it – foolishly. Why is that foolish? All investments are expressive, even though that fact is not often talked about in the investing community (Statman 2011). For example, calling oneself a “value investor” is more than a strategy for returns: it’s part of an investor’s identity as a rugged, independent thinker. Stock picking is more than making strategic bets; it can also express insight and a willingness to take on risk. “Low-cost” investors can express that they’re bargain hunters. Investors in Tesla gain (potential) returns and something they tell their friends. Et cetera. Sustainable investors, like any other investors, can feel an expressive benefit from their choices (see sidebar at left).
In addition to signaling our value and status to others, investments can also have an emotional impact on investors themselves. Investors may feel good or bad about a company and feel positively (or negatively) about owning part of it accordingly. With sustainable investing, the emotion one feels towards with a company and their practices is clearly important to some investors.
Similarly, investors may feel an emotional benefit from the impact their investments have on the environment, social policy and so forth.
As with other aspects of investing, though, there isn’t anything unique about sustainable investments. Some investors have a positive emotion toward Apple or towards Facebook because of their familiarity and feelings toward the brand, which drives up prices. Some investors enjoy the thrill of actively trading in the markets, even though that generally undermines their long-term performance (Barber and Odean 2000).
Again, what appears to be unique about sustainable investments is the emotional polarization that some advisors and investors have around it. The mere discussion of sustainability factors riles up some people; see for example the comments Morningstar received when it released data about sustainable investments (Hale 2016). Such strong emotions are likely to drive prices and performance over time, above and beyond the fundamentals of the companies and funds involved (Statman et al. 2008).
Whether or not the advisor shares the client’s perspective, emotions are part of the investment process: positive and negative. Wise advisors acknowledge the emotional aspects of investing, and work with them or around them to help their clients meet their long term goals.
Fixing a Disconnect