ESG and Behavioral Finance: Why ESG Investing Is Primarily a Psychological Phenomenon

Using a behavioral finance framework, I extend traditional portfolio selection theory and traditional asset pricing theory to accommodate environmental, social, and governance (ESG) investing. There are two behavioral innovations to behavioral portfolio selection. First, investors have preferences over the sources of their returns, which involves intangible benefits, possibly influenced by financial firms' marketing efforts. Second, investors are vulnerable to biased judgments about ESG impact and return distributions. The first innovation leads to a different notion of diversification than the traditional approach. This innovation also impacts the character of asset pricing, especially the nature of mean–variance efficiency, risk-free securities (green and brown), and arbitrage. I discuss conditions under which ESG asset pricing features a natural factor pricing structure. In some circumstances, the resulting equilibrium will conform to the CAPM with a single pricing factor—the market portfolio. In other circumstances, there will be more than one factor, and one of the factors will be the market portfolio. In yet other circumstances, there will be more than one factor, but the market portfolio will not be among them. This is especially the case in the presence of heterogeneous judgmental errors, both about returns and about ESG opacity.