Driven by an understandable desire to back socially responsible companies, environmental, social, and governance (ESG) investing is a growing trend among global investors. But it’s easy to overlook the psychology of ESG investing — including how biases can impact how professional investors understand their clients’ ESG-related preferences, and how professional investors make ESG-related investment decisions themselves. While the psychological forces are often deeply ingrained and difficult to overcome, there are ways professional investors can weigh these biases and make better choices.

ESG Investing: Meeting Client Needs?

A recent report by CoreData Research surveyed more than a thousand global investors, including institutional pension funds, family offices, sovereign wealth funds, and wholesale funds. When it looked at what drives ESG-related decisions by these investment professionals, it found that ESG investments often center on aligning with what clients want. Survey respondents overwhelmingly indicated that meeting clients’ needs was the top consideration for ESG investing.

But is that truly the case? What we think clients want is often based on what they say they want. But what clients say they want isn’t completely tied to what they actually want and need.

That’s because biases in decision-making run throughout their thinking, especially when self-reporting. These biases also affect how investment professionals interpret what clients want, and they can play a role in how we incorporate those insights into an investment process. This is where psychology comes in. Understanding psychological factors provides insight into making better ESG-related investment decisions.

Unpacking Biases

In the CoreData survey, respondents were asked, “What percentage of your ESG focus is allocated to each of these three segments: environment, social, and governance?” Wholesale institutional investors, for example, said they would allocate 44% for environmental, 25% for social, and 30% for governance.

But consider how respondents arrive at their answers. People are attuned to how questions are framed. Psychological research is littered with examples where the same question elicits very different results based on how it is worded.

In this example, the framing of the question makes E, S, and G appear mutually exclusive, rather than integrated. Governance, social, and environmental factors often overlap, which makes it challenging to separately add them up in a neat package. The way the question was asked omits this nuance.

Lack of clarity is another issue. When the question is, “What percentage of your ESG focus is allocated to each of the three segments?” what does the word “focus” mean? Maybe it means level of importance, but what if it means the amount of time spent on each thing or how many dollars are invested in each? Even if it was made clear that the word “focus” means time allocation, you might still have an issue. Most of us do not meticulously track hours according to each focus area, so the respondent will simply have to guess.

Social desirability bias can also affect how people respond to surveys. People tend to over-report preferences they believe are socially desirable, but — in practice — these same people may act in ways that contradict their espoused viewpoint. For example, I might be asked if I’m concerned about plastic in the ocean killing marine wildlife, and I’d say “yes.” Then you observe me down at the local supermarket filling my plastic grocery bags. Should investment professionals align their ESG investments with what clients say, or with their actual preferences that they reveal through their behaviour?

The empathy gap is similar, resulting in failing to empathize with our future self. People might claim in the abstract that they’d invest in a company dedicated to achieving a 10% reduction in carbon dioxide emissions, but in the real world, myriad factors — context, emotion, whether they’ve slept well, how many clicks it takes to get through an investment process — might affect their actual propensity to do so.

Delivering the Promise: ESG Investing

Inconsistency and lack of reliability in the ESG process are two of the greatest hurdles that investors cite as barriers to their further uptake of ESG.

This is consistent with research that shows that the most effective way to improve complex decision-making is typically to improve consistency and reduce “noise,” rather than to reduce “bias.”

One way to help achieve this is to quantify different aspects of human judgment across an ESG-related investment decision-making process. Among the practical things you can do to achieve this is to create a five-point rating scale that you can apply to measure each component of an ESG assessment. You can also create a checklist and commit to using it every time you evaluate an ESG investment to ensure you’re weighing factors in a consistent manner. Similarly, well-designed guidelines can help create consistency and mitigate bias throughout an ESG process. Turning your qualitative findings into quantifiable metrics will create rigor around aspects of human judgment that can easily slip under the radar. That’s how to deliver on the promise of ESG.

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About Simon Russell

Simon is uniquely placed to discuss behavioural aspects of financial product design, investment processes, financial advice, and financial product distribution in the Australian market. He is the founder and Director of Behavioural Finance Australia (BFA). At BFA, he provides specialist behavioural finance training and consulting. His services are designed to improve financial decision-making, communication, and engagement. He mostly works with fund managers, major super funds, financial advisers, and other financial services professionals. Simon is the author of three books on behavioural finance and is currently writing his fourth: Behavioural Finance — A guide for listed equities teams.”

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This financial industry article was adapted from the GLG Roundtable “The Psychology of ESG Investing.” If you would like access to events like this or would like to speak with financial industry experts like Simon Russell or any of our approximately 1 million industry experts, please contact us.