Measuring ESG preferences: from binary to behavioural

October 26, 2022


Globally recognised expert in applied decision science, behavioural finance, and financial wellbeing, as well as a specialist in both the theory and practice of risk profiling. He started the banking world’s first behavioural finance team as Head of Behavioural-Quant Finance at Barclays, which he built and led for a decade from 2006.

Measuring ESG preferences: from binary to behavioural

Measuring investor ESG preferences has gone from a nice-to-have to a must-have. Without behavioural forethought, how to do it risks prioritising the false economy of easy pigeonholing over a genuinely valuable understanding of an investor’s preferences.

Assessing an investor’s sustainability or ESG preferences is an integral part of the process of suitable portfolio construction. Common sense says so. The trendy bandwagon says so. The regulations say so.

However, there is an inherent tension between assessing sustainability preferences and constructing a portfolio.

Portfolios are designed for the long-term. Yet preferences for doing social good with one’s investments are likely to be heavily influenced by short-term emotional responses to world events.

Fortunately, there is a way to assess sustainability preferences that overcomes this tension. Unfortunately, one of the typical approaches – screening out companies in undesirable industries – while it looks simple on the surface, can quickly become both complicated in its execution and unsatisfactory in its results.

Asking an investor to work through a checklist of potentially unwelcome investments – e.g. tobacco, arms, oil – has a mechanical appeal, but its binary nature is also a problem. Because they’re affected by short-term emotional reactions, the relative strength of preferences for particular causes are highly variable.

This makes screening preferences difficult to monitor, and difficult to reliably reflect in a long-term portfolio. For example, big pharma was unpopular until the Coronavirus pandemic. Investing in arms seemed unimaginable until the invasion of Ukraine.

While such specifics can certainly help determine what somebody should invest in, they need to be supplementary to the more stable psychological preferences behind them.

From binary to behavioural

Financial personality traits are far less likely to change than prevailing preferences for what specific industries to screen for. A portfolio aligned with a financial personality is likely to remain compatible with its holder’s values whatever the news throws at it.

Oxford Risk has studied investor psychology as it relates to sustainability preferences across thousands of individuals, right across the globe.

The two main factors – and therefore the starting point for aligning a portfolio with social goals – are, broadly speaking: a) how much good someone wants to do via their investments; and b) what trade-offs they’re willing to make to do that good (for example, taking on extra risk, or sacrificing financial returns, or liquidity).

Another important factor to consider is an individual’s need for evidence – what proof do they want to see that an investment is actually having the positive impact it promised?

These factors, and others like them, can affect both portfolio construction and client communication: an investor’s emotional comfort with their investments is often as much a matter of the way in which they are encouraged to think about their investments as it is what they are actually invested in.

Financial personality factors, especially those relevant to aligning social goals with investments, provide a much more fundamental base to work from than a checklist that investors may complete without too much thought for either how well it reflects their deepest values, nor its long-term portfolio consequences.

The Oxford Risk approach to assessing sustainability preferences includes relative weightings for each of the UN Sustainable Development Goals (SDGs). These offer both a wide range of potential cause concerns, while staying high-level enough to offer a good level of stability.

Individual preferences for particular causes are clearly important… but they are better discussed after relevant personality traits have been established, to fine tune a portfolio and the narratives with which it is presented, not to drive them.

Find out more about how to comply with upcoming MiFID regulations whilst meeting growing investor demand and opportunities for ESG in our guide, ESG: The Compelling & The Compliant.

ESG: The Compelling & The Compliant - Download the Guide Now

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