Behavioural Finance and Sustainable Finance
While behavioural finance highlights the irrationality
related to non-financial factors, responsible finance precisely
finds its rationality in extra-financial aspects.
Responsible Finance: we revisit this 'investment philosophy' through the lens of behavioural finance, which we have shared with our clients for a long time. This discipline is defined as the application of psychology to finance. It teaches us that investors' decisions are not solely driven by the pursuit of optimizing the risk/return trade-off. The foundational work of behavioral finance does not mention responsible investing. However, it highlights a list of tendencies—called 'biases'—that unconsciously influence our financial choices and divert us from seeking the best balance between risk and return.
The choice to invest responsibly results precisely from an approach that goes beyond a reflection conducted solely through a financial lens. Of course, responsible investments, mainly through the commitment to sound governance of the selected companies, help reduce certain risks such as reputational risk, fraud, or managerial dysfunctions that could affect the company’s valuation. Regarding returns, the performance gap (outperformance or underperformance) linked to investments in issuers compliant with the rules generally prevailing in CSR1 policies, or the consideration of ESG2 factors, is not proven by academic or empirical studies. These performance differentials primarily depend on sectoral dynamics; thus, the exclusion of certain sectors (for example, coal mining or the oil industry) will positively impact portfolio performance in the event of a decline in that sector and, conversely, penalize it in the event of a rebound in the stock prices of companies belonging to that industry.
While it cannot be asserted that investment incorporating Environmental, Social, or Governance criteria follows a purely financial logic, it can be considered that such investments also correspond to a specific approach to investing, which is by definition non-financial. It is also worth mentioning that the ESG filters commonly applied are referred to as 'extra-financial' investment criteria.
These responsible investment decisions, guided by criteria that go beyond pure financial rationality, share a common approach with behavioural finance. However, while behavioural finance highlights an irrational aspect from a purely financial perspective, responsible finance precisely finds its rationality outside of financial criteria alone. More precisely, it finds different rationales because there are a multitude of reasons for our clients to be interested in responsible investment solutions. These reasons may include concerns related to climate issues, a societal commitment (altruism), a form of personal ethics, a contribution to well-being (giving meaning to one’s investments), or simply the consideration of a new type of risk.
This apparent 'irrationality' is actually a sign of an expanded rationality: the choice of responsible investment is not limited to financial return.
How to better control unconscious mechanisms in responsible finance?
While no mechanism can fully compensate for the effects of cognitive biases, the dialogue between the client and their advisor, particularly regarding the client's preferences, constitutes a first step. It allows for assessing risk tolerance but also for clarifying expectations regarding the sustainability of investments, liquidity, or return on investment, and sometimes even formalizing ambitions in a 'family charter'. For some clients, this document sometimes enables an intergenerational dialogue that unites the family and aligns wealth management projects with family values.
Beyond this exchange, clarity of information about a solution – ESG criteria, alignment with the Sustainable Development Goals (SDGs), impact indicators in particular – as well as support from the private banker or experts, are all levers to better inform decisions and limit the effects of cognitive biases.
Finally, knowledge and expertise play a decisive role in guiding towards an increasingly informed choice. Many financial players, beyond training their own teams, also seek to raise their clients’ awareness through dedicated approaches or training. Informed private investors, aware of ESG issues and the limitations of products in terms of impact, are often more discerning in their choices. However, this is provided they do not fall into the overconfidence bias; a bias that consists of overestimating one’s ability to select the right investments.
A judicious combination for better investing with awareness and purpose
Responsible finance is not limited to a mere pursuit of financial performance. It also reflects an expanded rationality, driven by values, commitments, and personal convictions. Behavioural finance, on the other hand, focuses on what goes beyond the risk/return pair to understand the psychological drivers influencing investment decisions. Combining these two approaches allows for better investing, with awareness and purpose.
(1) CSR: corporate social responsibility (CSR) refers to the consideration by companies of social and ethical issues in their activities.
(2) ESG: refers to Environmental, Social, and Governance criteria, which generally constitute the three pillars of extra-financial analysis.
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Analysis with Edouard Camblain, Investment Advisor and Behavioral Finance Expert at Societe Generale Private Banking.
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