Risk warning

The value of investments, and the income from them, can go down as well as up and an investor may get back less than the amount invested.

Sustainable investing has been on the rise in recent years, as investors have become more aware of the environmental and social impacts of allocating capital. Given this increasing interest, it stands to reason that regulators are keen to introduce legislative measures to promote good client outcomes.

In the UK, the Sustainable Disclosure Requirements (SDR) is one such package of measures, with further obligations for advice suitability processes expected. The regulator aims to help clients understand what they are invested in, and what the solution is designed to do, whether it's an exclusion-based fund, an impact fund, or a sustainable multi-asset risk-profiled fund.

Has your sustainably minded client had a change of heart?

Sustainable investments achieved largely positive returns for an extended period as interest in them peaked amid a boom in growth stocks. However, more recently, market volatility and their relative underperformance given the change in market style, have led some investors to question the merits of responsible investing strategies.

There may be a behavioural bias consideration for advisers to think about...

This apparent change of heart on the basis of market performance suggests a further look at client suitability and a greater focus on a client’s needs and objectives are in order. If a client is truly a ‘sustainable investor’, should relative market performance be a reason for them to suddenly switch their views on responsible investing? Or is there something else going on?

It’s possible that behind a client’s proclivity to be sustainable or not with their investments, there may be a behavioural bias consideration for advisers to think about in preparation for their client engagements.

Gap analysis

Biases can play a significant role in shaping investor behaviour, and can harm investment outcomes. This has been called the 'behaviour gap'. In other words, the difference between the return that investments produce when an investor makes rational decisions, and the return investors earn when they make choices based on emotions.

Behavioural cognitive biases affect how we process information, perceive others, and make decisions. Biases can lead to irrational thoughts or judgments based on our perceptions, memories, or individual and societal beliefs. The exponential increase in information flow over the past few decades (the internet/democratisation of information/24-hour rolling news/social media) means our brains make short cuts when faced with complex information or an intricate  situation. Our behavioural biases can take over and influence our thinking (for better or for worse).

Essentially, at a basic level we're hardwired for base emotions such as fear. An example was the UK government’s Emergency Beacon test on 23 April 2023. When this well-meaning initiative was announced at the end of March 2023, a negative narrative trended across social media channels, with commentators suggesting this was the UK preparing for nuclear war.

In fact, research shows that 'trigger warnings' (intended to signal to audiences that content may contain a negative or harmful stimulus) are potentially unfit for purpose. Experiencing a trigger warning is enough to make an individual anxious[1].

Fight or flight?

When we experience fear or stress (perhaps brought on by market volatility), our prefrontal cortex, (the part of the brain responsible for logical thought) is impaired. At the same time our sympathetic nervous system triggers an emotional ‘fight or flight’ response. When investors learn to understand the impact of biases on decision-making, it can change the way we look at and experience volatile investment markets.

Time to REACT?

We've compiled a list to help advisers to REACT to some of the most common cognitive biases that can affect interest in sustainable investing:

R - Recency bias

  • Our decisions are heavily influenced by recent events and the status quo. 
  • Recent market experience has affected sustainable fund performance. In 2022, portfolios that were light on fossil fuel energy stocks underperformed relative to the market. Such short-term underperformance can disturb investors, regardless of the longer-term investment outlook

E - ‘Everyone’s doing it’ aka herding bias

  • We seek to conform with group behaviour and prevailing norms.  
  • Some investors may have made decisions based on a wider societal shift towards sustainability, not necessarily because they are true sustainable investors.
  • Qualifying a client’s views and educating them on sustainable themes can promote good client outcomes (“sustainable” or not).
A - Aversion to loss bias
  • Research shows that we feel the pain of financial loss 2.5 times more than the pleasure of financial gain[2]. This focuses our minds on short-term views, regardless of our long-term investment horizons.
  • Large profits posted by energy and oil companies in 2022 could create a FOMO effect (fear of missing out). This links strongly to recency bias.
C - Compelling narrative bias
  • Narratives influence our beliefs and behaviour relating to environmental and social issues. 
  • Investing in a sustainable index fund typically excludes parts of the market on ESG (environmental, social and governance) grounds. When those excluded investments do well (energy/oil/thermal coal as per 2022), it doesn’t mean the sustainable fund has failed to perform.  By design, the fund is doing what it was built to do – exclude those assets.
T - Truth - aka confirmation bias
  • People seek out information and data that confirms their pre-existing ideas. 
  • They tend to ignore contrary information that goes against their fundamental views. This is perhaps why we see a demographic split in interest in sustainable investing.

Advisers who understand these biases can use them to help manage client confidence and steer clients to understand the suitability of their investment choices - sustainable or otherwise.

Additionally, it's important to help clients understand the features and objectives of a sustainable investing solution. The SDR labelling regime will help illustrate that not all sustainable investing solutions are the same.   

Qualifying your client’s sustainable views and evidencing these within the advice process will be essential.

The SDR and Consumer Duty will add further focus and scrutiny onto the existing advice process obligations of KYC, COBS and PROD*. Qualifying your client’s sustainable views and evidencing these within the advice process will be essential. There will also be an emphasis on how advisers segment their clients, align appropriate investment solutions, and manage attitude to risk.

Final thoughts

Irrespective of your views and choice of CIP (centralised investment proposition), industry-leading multi-asset solutions providers can offer you options across passive, active, and sustainable investing.

Visit our website to find out more about multi-asset solutions designed to meet your clients’ needs and long-term financial goals.

*KYC = Know Your Client, COBS = Conduct of Business Sourcebook, PROD = product intervention and product governance

  1. Source: The Conversation, an independent source of news analysis and informed comment written by academic experts, December 2022
  2. Source: InsideBE. Loss Aversion – Everything You Need to Know