“In order to do good economics, you have to keep in mind that people are human.” — Richard Thaler, Nobel Prize winning behavioural economist (1)
As Richard Thaler reminds us, it is important to keep in mind that when we speak of investors, we are speaking about human beings. Not machines.
So, when we speak about what actions investors are taking (or could take) to ‘manage the risks and capture the opportunities associated with climate change’ we need to also consider the behavioural dimensions to that assessment. That is the basis for a new research programme on Investor Behaviour and Climate Change (2).
The research will look at a range of behavioural tendencies to consider how these are impacting on investors’ ability and willingness to incorporate climate change into investment decisions. It starts with the premise that investors, like all humans, have limited rationality (3). Investors, like all humans, are bounded and influenced by social norms and preferences. Investors, like all humans, revert to the use of well relied upon ‘heuristics and rules of thumb’ to inform and make decisions under uncertainty.
What are the consequences of these traits of humanness in terms of how investors are willing and able to respond to what Mark Carney described as the potentially “catastrophic impact” (4) that climate change could have on the financial system?
Well, for one thing, the solutions to mobilise and support investor action on climate change go beyond more data and metrics. As important as these are to supporting investors in their quest to adequately manage the financial impacts of climate change for investment portfolios, more data and metrics will not be enough to shift investor behaviour en masse.
For investor behaviour to shift en masse, we need to understand the drivers that underpin investment decisions, many of these are behavioural rather than data-driven. This research programme will look at three main areas of investor behaviour, drawing from economic psychology, behavioural finance and sociology, namely: short-termism, heuristics/rules of thumb, and herding/gravitation to defensible decisions.
Let’s start with the natural human tendency to overly discount the future, or short-termism as it is more widely known. It is widely accepted that short-termism is prevalent amongst investors, and a challenge that needs to be overcome to manage a system-wide and multi-period risk such as climate change (5). However, the suggested antidotes are few and far between, most of which revert back to the assumptions underpinning rationality, such as improving access to data (hoping that better data will lead to better decision making) and/or revising financial incentives (assuming that these are the dominant driver of behaviour).Areas that warrant further exploration are the psychological, social and cultural underpinnings of investor behaviour. For example, the importance of questioning existing narratives and framing (e.g. I need to outperform the benchmark), culture (e.g. no one else really talks about climate change in my team), choice architecture (e.g. my consultant doesn’t present me with low carbon opportunities so I don’t know what is out there), power relations (e.g. the patriarchal structures that prevail and sustainability champions sidelined inside their organisations) and perception of risk (e.g. should I focus on more pressing issues?).
“The programme will look at three main areas of investor behaviour, drawing from economic psychology, behavioural finance and sociology”
(2) Heuristics and rules of thumb
Another human tendency that will be explored in the context of climate change and investor behaviour is the use of heuristics or rules of thumb in decision making under uncertainty. This tendency to rely on a narrow set of parameters or signposts to underpin decisions as researched through the seminal work of Kahneman and Tversky (6) revealed that humans prefer simplicity, have a limited attention span and go out of their way to avoid hassles (7). Climate change is often perceived as a complex topic with a high degree of uncertainty, potentially demanding more time and effort from investors to incorporate it into their mental models and decision-making processes.
(3) Herding, group think, or gravitation to defensible decisions
There is growing evidence that investors have the tendency to mimic the behaviour of others and act according to the ‘rules of the game’, whether consciously or unconsciously. As the Keynes beauty contest analogy posited (8), there is safety in numbers, if everyone gets it wrong then they all go down together, there is less reputational risk than going alone. To the extent that climate change is not yet ‘conventional’ amongst investors in terms of day to day investment decision making, it may feel riskier to take decisive action.
Survey – your responses are needed!
The first part of this research programme is a survey on investor behaviour and climate change. You are invited to complete the survey by clicking here. It will take about 5-10 minutes and all responses will remain anonymous. The findings will be published in a research paper.
Dr Danyelle Guyatt is a Sustainable Investment Specialist and Managing Director of Collaborare Advisory. For notes, please see overleaf.
(2) Led by Collaborare Advisory, supported by Climate Works
(3) Shiller, R. J. 2000, Irrational Exuberance, https://journals.gmu.edu/PPPQ/article/viewFile/333/261
(4) https://www.theguardian.com/business/2018/apr/06/mark-carney-warns-climate-change-threat-financial-system(5) https://www.bis.org/review/r151009a.pdf