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Risk & Behavior

What’s Behind the Feel-Good Vibes of Sustainable Investments

The role of the halo effect in investing

The mind can play tricks on you. Let me give you an example.

For a study, researchers Patrik Sorqvist and his colleagues randomly divided participants into two groups. They asked them to taste two cups of coffee and indicate which they preferred. Unbeknownst to the participants, the coffee in the two cups came from the same brew. But before the tasting, the researchers told one group that one cup contained eco-friendly coffee. This group reported that the eco-friendly coffee tasted better than the alternative, even though the coffee was the same. They also were willing to pay more for it. This is what behavioral researchers call the halo effect.

What is the halo effect?

The halo effect is the tendency to establish an overall impression of a person, brand, or object based on the influence of a specific, usually positive, attribute. That’s because our minds are wired to take shortcuts.

The halo effect is subtle. Most people aren’t even aware if they are under its influence or not. As the coffee experiment shows, having “eco-friendly” attached to an otherwise identical cup of coffee reportedly improves its taste and the willingness of people to pay more. This is not rational, at least in the conventional sense.

Leveraging the halo effect in investing

Behavioral biases often creep into how people make decisions and can lead to outcomes that aren’t optimal. As a behavioral researcher, I often caution people against behavioral biases and formulate ways to help investors overcome them. There is a significant chance that investors who are looking to invest sustainably are exhibiting the halo effect in the same way as the participants in the coffee experiment. Sustainable investments give investors the opportunity to enjoy the “warm and fuzzy” glow of the halo effect while they feel they are doing good with their pocketbook.

But the halo effect could have good and bad consequences for those with sustainable investments.

First, the bad

Like the participants in the coffee experiment, investors who are looking to invest sustainably may be “blinded” by the halo effect in investing and evaluate investments exclusively through the lens of sustainability. In doing so, an investor could underplay key metrics, such as fees, and overlook how a sustainable investment fits (or doesn’t fit) into an overall investment portfolio.

Investors should not rely on sustainability as the lone selection criterion in their portfolio management, no matter how good it makes them feel.

Now, the good

The halo effect from investing sustainably may have the unintended consequence of nudging investors away from overreacting to market movements and toward long-term investing.

Some preliminary research shows that sustainable investors are less sensitive to short-term fluctuations in the market and tend to adopt a “buy-and-hold” investing strategy. Part of the reason could be that investors are reluctant to part with the “warm and fuzzy” feelings associated with their sustainable investments. Those feelings prevent them from giving into their behavioral biases and overreacting during market corrections. As a result, and perhaps unintentionally, sustainable investors end up investing in the long term. In short, they are doing the right thing (buy-and-hold) for the wrong reasons (fuzzy feelings). But that’s OK because it helps investors stay on course during times of volatility.

Admittedly, we need more research to figure out if the tendency for sustainable investors to invest with a long-term horizon is because of the halo effect or other circumstances, such as a lack of alternate investment options that meet their non-financial needs. Nonetheless, it appears that sustainable investments can help encourage investors to invest for the long-term.

2 ways to help your clients strike a balance with sustainable investments

  1. Harness the halo effect to their benefit. Help clients allocate a portion of their wealth to sustainable investments. In doing so, they can reap the emotional benefits of “doing good” with investments that help them stay on track for the long term.
  2. Use sustainability as one, but not the only, factor in considering investment options. Consider sustainability alongside other key metrics. For example, use sustainability to break the tie between two otherwise comparable funds.
Read our paper “The Many Dimensions of Sustainable Investing” to learn more about building a sustainable portfolio.
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