Avoid classic behavioural traps when buying ethical investments

Dr Greg Davies is head of behavioural finance at Oxford Risk.

When lots of people vaguely want something, but nobody knows precisely what they want, or seem inclined to find out, you’ve got a recipe for disappointment… and manipulation.

Investors looking to align their social and investment goals through ‘environmental, social and governance’ investment opportunities face just such a problem.

Investing – especially ESG investing – is a highly emotive experience. When individual investors are searching for the investments most suitable for them, their psychology is central to the process.

For most ESG investors, the quality of their investing experience is about much more than mere numbers. It’s about the emotional comfort that these things do what they claim to do, and trusting in independent parties to verify those claims.

ESG investment products, however, are typically designed without an understanding of individual investors’ preferences.

This enables investment managers to slap a generic ESG badge on the tin, deciding on behalf of their clients what they do or don’t care about, and this results in one-size-fits-all solutions that don’t reflect the values of most investors.

Without a standardised menu of meaning, ‘ESG’ on a fund label is becoming as meaningless as ‘natural’ on a food label.

Yet sadly, such labels are often all investors have to go on; and being asked to trust everyone is grounds for trusting no one.

This is especially the case when you consider the polarising tendency of ESG news to flick between it being the answer to all the world’s ills, and a total ‘greenwashing’ scam.

At my firm, we’ve been tracking responsible-investing preferences for years, and it’s clear that investors interested in ESG are trying to meet many different – and often contradictory – goals.

To take only the most consequential example: some are not only willing, but positively keen to make financial trade-offs to do social good. Others are not. Some want to see a big positive impact. Others are happy with simply screening out the worst sinners.

The priority for all ESG investors should be to get clear on their priorities prior to making an investment.

To what extent are you willing to give up financial returns for social ones? What evidence do you want to see of the social good being done? Are there particular causes you want to support?

Would your goals be better met with direct philanthropy? Would you rather have an investment manager who engaged with potentially ‘sinful’ companies in a bid to change them, or who simply divested from them?

Promises on labels can be tempting – not least because they suggest we’ve found the shortcut we were looking for. However, to avoid ultimate disappointment, and make the most of an ESG investment, the key is to not to turn off, but to tune in. 

What are the classic behavioural traps ESG investors should avoid?

1. Don’t be blinded by the numbers

It is always difficult to choose the right investment. So, we often just pick the one that looks best on some easily available metric.

This drives much of our tendency to chase past performance in investing: don’t know which fund to choose? Just pick the one that did best last year.

In ESG particularly, however, what is measured is often quite different from what matters. And available ESG scores from different providers show surprisingly little agreement with each other. If you have the time, dig deeper to do the most good. 

2. Be prepared to make trade-offs

The asset management industry likes to pretend that you can do all the good you want in the world without any cost to returns.

This is certainly true of some investments: sustainability is sensible after all.

However, ESG investments that would be bought anyway, even by investors who don’t care about ESG, aren’t the ones that need your help.

If you’re truly concerned about ESG you need to push a little harder, and be prepared to sacrifice some returns, or take on some more risk.

Our research shows that around 70 per cent of investors are willing to give up some returns if they know they will have a positive effect on the world as a result.

This shouldn’t come as a surprise as, after all, most people accept minus 100 per cent returns when they give money to charity. Be clear in your mind the trade-offs you’re willing to embrace. 

3. Divesting feels good, but doesn’t always do good

Selling all fossil fuel holdings may give you a warm glow, but it is worth noting that this doesn’t directly change any money flows going to those companies.

Everything you sell, someone else buys, and they likely care less about the environment than you do.

Divestment is an easy option, but to do the most good it may be better to stay invested and push your investment manager to engage more with the management of those companies, and more effectively wield your vote at their shareholder meetings.

If we can all apply more pressure on these companies to change, we may collectively be much more effective than by selling out. 

4. Don’t follow the herd

Buying the ESG options that are most popular feels comfortable, but firstly, is likely to mean you’re buying high, not low.

Secondly, the ESG options that the crowd is buying are the ones that least need your help. They’re being bought anyhow. Contrarian investing applies to ESG too. 

5. Don’t be daunted

It is easy to be put off by the complexity and novelty of ESG investing, cleaving instead to the comfort of cash savings.

But even an imperfect ESG investment is better for you than having your wealth sitting in cash year after year; and is better for the world too.

ESG investing is a win-win, so don’t delay, don’t let the best be the enemy of the good, and learn as you go.