Why do we invest ethically?
This report looks at investor behaviour, and contends that investors no longer behave in the “rational” fashion that traditional finance theory assumes. Studying the desire to invest ethically challenges the relevance of traditional finance theory, and helps improve our understanding of ethical investor behaviour.
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OVERVIEW
This article looks at the emergence of ethical investments, and proposes three reasons that people may choose to invest their funds ethically.
Superior financial returns
Since the early 1960s, the finance discipline assumed that investors are rational. In other words, investors prefer more to less; they juggle risk and return; and they demand higher returns to compensate them for taking on greater risk. There are no other influences on the investment decision. Personal values are irrelevant.
If investors actually behave as traditional finance theory assumes, ethical investment would exist only because it provides the opportunity for equivalent return at lower risk or provides higher returns for the same level of risk as standard funds. Such people would invest in an ethical investment if it provided a superior financial performance.
Non-wealth returns
By the 1960s, research was suggesting that investors do not uniformly exhibit rationality. Behavioural finance emerged, drawing on evidence from psychology literature to better explain finance phenomena.
For example, research suggested a tendency of decision-makers to be over-optimistic, and to over-estimate their own abilities. Concepts such as “anchoring”, “framing” and “noise” emerged.
One study emerged suggesting that individual preferences can interfere with the risk-return relationships among securities. They isolated five different investor groups with different investment goals, investment approaches, and portfolio compositions. Another study found that age, sex, income, and education affect investor preference for capital gains, dividend yield, and overall return.
Yet another study, examining investors’ most significant factors in their decision making, found that wealth-maximising criterion were considered important by less than half the study sample. The variable coming third in the list of significant factors was “feelings for firm’s products and services,” – seen as an emotional and “non-rational” decision driver.
At the time of writing this article (2005), evidence was emerging that ethical or socially responsible investment (SRI) was growing as a legitimate focus of discussion about investor choice. Investors were becoming recognised as more complex than previous theories would suggest, and that they apply many criteria in the decision-making process.
Contributing to social change
Ethical funds may be defined as “retail financial products that specifically add social or ethical goals or constraints to normal financial criteria.” The question is why investors would support additional goals in the investment decision.
The article suggests that non-wealth motivations for ethical investment are the most likely explanation for the demand for ethical funds. To pay the higher transaction costs for what is essentially the same product, customers must derive a benefit from the branding as an SRI. They gain their psychic returns from the outcomes of the activities of the firms in which they invest.
The authors conclude the main benefits SRI fund investors derive from the social change aspect of their investment is one of psychic return—feeling good about not supporting undesirable activities. These investors are motivated by all three of the proposed objectives, with the social change factor being the least important in the decision to invest in an SRI fund.
KEY INSIGHTS
- Traditional finance theory does not consider any influences on the investment decision apart from maximising returns, given the individual's particular level of risk aversion. Subsequent research suggests that there are in fact many more influences at play on the investment decision.
- Investors use a diverse criteria in their investment decisions and do not approach those decisions in a normative fashion.
- Traditional finance theory and ethical investment literature combine to provide reasons people may invest for an ethical purpose. These include: for superior financial returns; for non-wealth returns; and, to contribute to social change.
- The main benefits SRI fund investors derive from the social change aspect of their investment is one of psychic return - feeling good about not supporting undesirable activities - rather than from any tangible external benefit of making significant change.
- There is a "fun of participation" model which provides a good depiction of some investors' utility function. The investor wants to achieve close to a market rate of return with the additional feel-good factor from the status of 'ethical investor'.
- The requirement of a financial return is necessary for an activity to be considered an investment, but there may be a trade-off between financial and psychic returns for some investors.
- Psychic return can be viewed as an increase in happiness, an approach that would lend itself to empirical testing to improve our understanding of why we invest ethically.
- Advancements toward a theoretical economic framework for ethical investing have led to a combination of psychology and happiness research with orthodox financial economics.