As advisors we aren’t always successful when we caution clients against buying when the market is high and panicking when the market drops. Penn-Tracy explains that sustainable and impact investing supplies the missing piece in the traditional advisor client relationship. “What we’re seeing is that if you incorporate clients’ values and what they care about into the investment process, they see their investments as an expression of those values,” says Penn-Tracy. “They react less to external market triggers and become more resilient investors.”
In fact, the study shows sustainable and impact investors most resemble passive investors. “The only group of investors that performed better in the face of market ups and downs were passive investors,” says Penn-Tracy. “And we think this is because passive investors are often inside 401K retirement accounts that are mostly invested and then left there.” Interestingly, sustainable and impact investor behavior is even better than that of institutional investors.
Penn-Tracy also points out that the study data included a sustained period of growth and low volatility in the markets. Although some high volatility was captured in 2008, for the most part the extended period of growth leading to a tightening of the performance gap suggests that investors might have become complacent. “What will happen,” Penn-Tracy asks, “when we have future market volatility?” This is where behavioral economics comes in.
Using Behavioral Economics To Understand Client Behavior
Behavioral economics uses psychology and decision theory to study the economic decision-making of individuals and institutions. One of the most significant concepts is how often people make even critical decisions irrationally. Penn-Tracy believes behavioral economics can help advisors better understand why clients sometimes make decisions that affect them negatively even when advisors support them to take a more rational approach to managing their investments. During our interview, Penn-Tracy focused on three key concepts advisors can use in building stronger relationships with clients:
Herd behavior: As individuals we tend to mimic the actions of a larger group, whether they’re rational or not. “We buy when we see the market has been going up and we feel we’re being left out,” says Penn-Tracy. “We feel we have to get in and match the return our neighbor is getting. It’s just normal human behavior but it works against us overall.” Sustainable and impact investors, on the other hand, tend to be more intrinsically motivated. They focus on issues that matter to them in addition to financial performance. As Penn-Tracy puts it, “We’re seeing that ESG and impact investors are internally motivated to stay invested, to stay the course.”
Loss aversion: People tend to be more afraid of losing than attached to winning. In investing, this can mean clients are more afraid of losing money than they are attached to gaining money, and therefore tend to make decisions based on fear. Penn-Tracy explains how sustainable investing can turn loss aversion into positive behavior: “What happens is that clients who are concerned about other issues, like climate change, for example, might fear loss of the ecosystem, or animal species. So that works to keep them invested in their ESG-focused investments rather than jumping out when the market has a downturn.”
Recency bias: Habits make life easier, and we tend to make decisions based on what’s happened most recently. This can play out in the markets, for example, when investors equate any significant downturn with the 2008 financial crisis. Decisions based on this assumption can result in selling at the wrong time. Penn-Tracy explains that sustainable and impact investors exhibit a different kind of recency bias. Important events in society or in the news can prompt people to move their money into ESG and impact funds: “After the Parkland School shooting, a group of investors came to me and asked, “What are we doing about weapons investing? Am I invested in companies that make these weapons?’” So rather than focusing solely on returns, these investors are looking at a bigger picture.
Having The Values Conversation
During our conversation, Penn-Tracy and I talked about the growing use of ESG metrics as part of risk analysis. She’s clear, however, that just having a risk conversation with clients isn’t going to engage them emotionally in a way that’s going to change their behavior: “As an industry, we need to stop pretending that emotions don’t matter and that deep convictions and values don’t matter,” says Penn-Tracy. “We need to talk to clients about what’s meaningful for them: What kind of world do they want for their grandchildren, their great grandchildren? Because when they engage deeply in those internal values and we match their investment with those values, that’s what creates investor resilience.”