ESG for Everyone: How to improve retail ESG investing

The ESG space is complicated: hundreds of rating agencies compete to build a superior set of standards, initiatives, and frameworks to measure impact more effectively. This leads to an alphabet soup of acronyms, each defining impact in its own highly specific, yet subjective fashion.⁵

As retail investors typically don’t have the time or resources to siphon through all of the ESG information available, they make investment decisions based on a simple heuristic: looking at ESG ratings. Unfortunately, focusing on ratings alone may be a recipe for failure. 

In 2019, Sustainalytics, an ESG rating company, altered its methodology for determining ESG risk. Originally, they had a 0-100 scale where higher numbers represented companies that were less risky on ESG factors. Under the new system, they flipped the ratings to make it more logically consistent: lower numbers represented less risky companies.^6,7

Due to this flip of the scale, many good companies received what appeared to be a dramatic downgrade (i.e. a company originally rated 88 ‘fell’ to 12). Obviously, nothing had actually changed – the most ethical companies still scored well. But many investors jumped ship, selling off ethical companies because their ratings had fallen, and buying less ethical companies because their ratings ‘went up’.^6,7 

The Morningstar switch revealed many retail investors use solely the ESG rating to evaluate the worthiness of investing.^6,7 This leads to unsophisticated trading strategies: if the score goes up, they buy. If the score goes down, they sell.^6,7 These strategies are likely to lose in the long run. 

Criticism about the legitimacy of ESG investing is emerging, as outraged impact investors are finding tobacco, big tech, and oil companies in their ESG funds.⁸ The presence of these companies doesn’t necessarily negate the value of ESG investing, but instead reinforces the idea that the idea of impact is subjective.

Traders need better clarity. The retail sector is rapidly expanding, with over half of all retail traders seeking to shift funds over to ESG investments.⁹  Additionally, diverse and novel demographics have shown explicit interest in getting into the investing space through ESG investing, unlocking new markets segments for trading platforms.³ 

But to make this process easy and accessible, we need to understand what behavioral barriers are keeping retail investors confused and disillusioned about ESG investing. 

The ambiguity and abundance of ESG information is overwhelming for at least a third of retail investors, deterring many from investing.³ This phenomenon is called information overload – the idea that when confronted with too much information, we get overwhelmed and shy away from the stressful situation.

If we do engage with an information-rich landscape, we tend to latch onto whatever information stands out the most, whether or not it is the most valuable or relevant. This phenomenon is called the salience bias, which leads us to develop blindspots. 

In ESG investing, the most salient information is ESG ratings. As a prominent, easy-to-understand indicator, investors latch onto it and overvalue its utility. This leads to irrational investments. 

We need to make ESG investing easier to understand, while increasing the salience of other relevant information. But how do we cut through the noise?

We must change the way ESG information is presented to retail investors. The EAST framework shows us that we must make the process of getting ESG information easier. 

Currently, there’s friction between retail traders and clear ESG information: ratings are not standardized, information is conflicting, and traders’ perceptions of impact may differ from the companies. We need to reduce this friction through optimizing the user experience of a potential investor. 

1. Personalized Impact: The First Step on the UX Journey

Imagine this: a retail ESG investor logs onto a trading platform and is given a query: “Which cause do you care about most?” Given a list of well-defined topics, the platform provides only the most relevant ESG scores to the user’s target cause.

This personalization increases feelings of agency, as well as streamlines the complicated ESG research process. The most relevant ESG ratings are then compiled into a list and presented to the user for their comparison. 

2. Simplifying the ESG Scale: the major key 

While each of these ratings have a different methodology and scoring system, each source has been put onto a simplified scale that simply defines if the rating views the ESG efforts in the target area as satisfactory, unsatisfactory, or exemplary, each assigned their own specific color to simplify the information further. Clear linguistic and color-coded scales help minimize the confusion associated with scales and potential changes in methodologies. 

3. Beyond the rating: ESG information at the tips of your fingers

If you click on each rating’s icon, you will receive simplified information about how the rating is formulated and its potential blindspots. Providing simplified, additional information increases the salience of alternatives to the ESG rating, as well as preemptively mitigating the disillusioning surprise that may occur when retail traders discover that their ESG fund holds a company they find unsavory.

The Idea: Simple, relevant and salient

The behavioral logic behind this design intervention is clear: in order to counteract information overload and an overreliance on singular ESG factors, we must make the process of ESG investing simple, personally relevant, and more salient than alternative information. 

In an era of converging crises, it feels difficult for an individual to change the world. It becomes even more difficult to create change when bogged down by information overload and ambiguity.  

To bring about the transformative power of retail ESG investing, a more streamlined and transparent ratings process will be necessary. Until then, however, there are simple behavioral design interventions that make the transformative power of ESG investing accessible for the everyday investor. 

By contrasting ESG scores on an easy-to-understand interface, we can decrease investors' feelings of ambiguity preventing them from investing. Additionally, by increasing the availability of fundamental impact information, investors can more accurately assess risk, invest in what they find personally impactful, and create change on their own terms. 

The Decision Lab is a behavioral consultancy that uses science to advance social good. Impact investing is a critical avenue for advancing the social good and combatting emerging crises. We have worked with leading organizations to remove the cognitive roadblocks that hinder optimal financial and social outcomes of their portfolios. If you are also passionate about transformative impact investing, contact us.