Llivia has a BSc in Psychology, and while working for us at Ethical Screening is studying for an MSc by research (with a focus on environmental and cognitive psychology) as a precursor to her planned PhD.
Sustainable Investing as a Cure for Bias?
When it comes to the links between sustainable investment and enhanced returns, numerous explanations focus on how companies that perform well in terms of sustainability/ESG tend to out-perform those which don’t.
There may, however, be other forces at play. Fundamentally, investment decisions are made by people, and people are driven by both logic and - crucially - emotions. As explained by research into behavioural finance, psychological factors, including biases, can influence decision making, and result in potential risks and opportunities being missed.
Sustainable investment strategies can potentially act as a remedy to bias, and thus allow investors to identify both risks and opportunities that they may otherwise have overlooked or discounted. Here, we will be focusing on the impact of four key biases: loss aversion bias, risk aversion bias, anchoring bias, and recency bias.
Loss Aversion Bias
In finance terms, this bias results in importance being placed avoiding loss, rather than pursuing increased gains. It occurs in individuals who experience stronger emotional responses to losing money compared with making more. As a result, such an individual may:
- Hold underperforming investments too long to avoid realising a loss.
- Favour “safe” but low-return options.
- Sell strong performers prematurely to lock in small gains.
Sustainable investment strategies may help to alleviate loss aversion bias by adding an additional layer of emotional and ethical value to investments. This layer may dampen emotional reactions linked purely to the financial value of investments, and how they are affected during market downturns. When focus is shifted towards long-term financial and social outcomes, investments may be viewed through a lens of greater good, even when returns fluctuate in the short-term.
Risk Aversion Bias
This bias derives from a preference for certainty, and the avoidance of perceived risks, even when higher-reward opportunities are available. It can result in overly conservative portfolios that miss out on growth opportunities.
By implementing sustainable investment strategies, risk aversion bias can be countered by providing investors with more confidence in their decision making. Incorporating ESG considerations, and working to identify companies more likely to perform well in a post-transition world, may assist cautious investors in overlooking purely financial risks. As a result, more opportunities are likely to be identified.
Anchoring Bias
Anchoring is the fixation on specific reference points such as past prices, historical trends, or what others are doing. Such “anchors” can guide decisions, even when other reference points are available. This leads to:
- Overreliance on conventional or familiar investment choices.
- Resistance to change, even when new data or better opportunities emerge.
- Trend-following behaviour based on outdated or irrelevant benchmarks.
Sustainable investing helps reframe decision-making around other (and often more forward-looking) factors, compared to primarily backward-looking anchors. By evaluating companies through a sustainability lens, investors can be guided by a vision of where the world is heading, not just where it has been. This can enable investors to:
- Invest with a strategic, long-term mindset, rather than being anchored to historical norms or fleeting trends.
- Support companies actively shaping the future, rather than reacting to the past.
By moving away from using conventional anchors, sustainable investing empowers individuals to make choices based on impact, resilience, and purpose, rather than habit.
Recency Bias:
Recency bias involves placing too much weight on recent or short-term trends, assuming they’ll continue indefinitely. This can cause irrational optimism during market highs, or unnecessary fear during downturns. When heavily influenced by this bias, investors may:
- Make buy or sell decisions simply because an investment has recently performed well or poorly.
- Overreact to short-term losses and abandon long-term strategies.
- Overlook broader systemic risks or long-term opportunities in favour of current events and observations.
Sustainable investing can help to counter recency bias by encouraging patience and long-term views, and by grounding investment choices in structural trends and global priorities. Opposed to strategies based on reacting to the latest market noise, sustainable and ESG investment strategies are based on deeper analysis of long-term drivers of value, and mean investors are less likely to be swayed by short-term trends and volatility.
To Conclude:
In addition to the regular explanations for why sustainable investment strategies can yield higher returns, answers may also be found in the minds of those making decisions. As emotional beings, logic may not always be the sole guiding force of those making investment decisions. While they will not result in decision makers relying purely on logic, sustainable investment strategies may help to alleviate a number of biases that these individuals hold.