L5 - Social Preference

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Lecture 5:
Social Preferences
Behavioral Finance (FIN 550E)

Xing Huang
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Behavioral Finance:
The topics
Prototypical economist conception of human behavior (Rabin, 2002):
Non-standard preference:
Non-standard decision making:
Non-standard beliefs: • Reference dependence:
• Limited attention: opportunity set • with as reference point (prospect
(neglect less salient alternatives) • Overconfidence: theory)
• Menu effects • Present-bias preference: time
• wrong or
• Framing inconsistency
• Law of small numbers:
• Persuasion • Social preference: where is allocation
• wrong forecast of
• Mental accounting of others
• Over-inference:
• Emotions and sensations
• excessive updating of
• Happiness
Integrate these findings into the market ➝

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Le ct u re O ut l i ne
• Social Preferences: Introduction
• ESG Investing
• Applications:
• Employee satisfaction and equity prices
• The price of sin
• Do investors value sustainability?
• Do investors care about carbon risk?
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Social Preferences
Introduction
• Simplified model of preferences of self when interacting with others:
• What do the following cases capture?

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ESG Investing
G o o g l e S e a r c h Vo l u m e
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ESG Investing
Firms making significant “green“ investments
87% of the companies on this list provided a "monetary bonus"

to executives that met sustainability goals.
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ESG Investing
Financial products are following suit
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ESG Investing
Main ESG Issues
Source: Matos, Pedro. "ESG and responsible institutional investing around the world: A critical review."
(2020).
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ESG Investing
Financial products are following suit
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Discussion
• Are firms’ sustainable and socially responsible investments costly or value-enhancing? Why?
• Are firms with ESG or socially responsible investment associated with higher or lower stock
returns? Why?
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ESG Investing
What is the goal of “green” finance?
• Different investors state very different goals
• Moral (Non-pecuniary, social preferences)

• Make the environment better
• Social issues
• Better corporate governance?
• Pecuniary
• Better returns or less risk
• Institutional
• Institutions mandated to implement certain goal
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ESG Investing
How is “green” finance measured?
• Some specific attributes

• E.g., no guns in the portfolio
• Specific mandate of active portfolio manager
• More commonly using an aggregate rating

• Take a set of different categories and average them
• Environmental, Social and Governance (ESG)

• Most common nomenclature for ratings
• Correlation of ESG across providers about 10%-15%
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Employee satisfaction and equity prices
• Employee satisfaction can benefit shareholder through two mechanisms:

• Motivation: increases effort of employees
• Retention of employees
• Measuring employee satisfaction:

• “100 Best Companies to Work For in America” published on Fortune
• Question: In an efficient market, how would the disclosure of a variable that is beneficial
to firm value affect stock returns?
Source: Edmans, A. (2011). Does the stock market fully value intangibles? Employee satisfaction and
equity prices. Journal of Financial economics, 101(3), 621-640.
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Dep var = the portfolio return of companies on the ”Best

Companies” list benchmark
• Benchmark includes:
• risk-free
• industry-matched portfolio
• characteristics-matched portfolio return
What does the positive abnormal return indicate?
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• Two hypotheses:
1. Market is not aware of the BC list

• The BC list was only published in book form before 1998 ( not salient)
2. Investors have difficulty in incorporating intangible info into traditional valuation models.
Full Sample Period (1984-2009) Salient-info Period (1998-2009)
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The Effects of Social Norms on Markets

The Price of Sin
• “Sin” stocks: publicly traded companies involved in the production of alcohol, tobacco, and gaming
• Questions:
• Who owns these stocks?

• Institutions (mutual funds, hedge funds, pension funds, endowments…) vs. individuals
• How does it affect analyst coverage?
• What are the effects of social norms on the returns to investing in sin stocks?
• Sin stocks  higher or lower returns?
Source: Hong, H., & Kacperczyk, M. (2009). The price of sin: The effects of social norms on markets.
Journal of financial economics, 93(1), 15-36.
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The Price of Sin
type 1: banks
type 2: insurance companies
Dep var: institutional ownership type 5: pension plans, endowments, etc.
----------
type 3: mutual funds
type 4: independent investment advisors
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The Price of Sin
Dep var: the return of sin stocks – comparable stocks
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D o I n v e s t o r s Va l u e S u s t a i n a b i l i t y ?
Source: Hartzmark, S. M., & Sussman, A. B. (2019). Do investors value sustainability? A natural experiment examining
ranking and fund flows. The Journal of Finance, 74(6), 2789-2837.
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G o o g l e S e a r c h Vo l u m e
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the initial publication of the

sustainability ratings
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X-axis: globes (sustainability rating)
Survey on MBA students and on subjects from Mturk
• Expectation of performance
• Expectation of risk
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Do Investors Care about Carbon Risk?
• Return of firms with High CO2 emission > Return of firms with Low CO2 emission
• Compensation for carbon risk  “risk premium” hypothesis

• Divestment from institutional investors (similar to “sin stocks”)  ”divestment” hypothesis
• Return of firms with High CO2 emission < Return of firms with Low CO2 emission
• Market underprice carbon risk  “alpha” hypothesis
Source: Bolton, P., & Kacperczyk, M. T. (Forthcoming). Do Investors Care About Carbon Risk?. Journal of Financial
Economics.
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Measure for CO2 emission
• Carbon Disclosure Project (CDP): a pioneer in producing company-level CO2 emissions data
• http://www.cdp.net/en-US/Pages/About-Us.aspx
• Three different categories:
• Scope 1: direct emissions from production
• Scope 2: indirect emissions from consumption of purchased electricity, heat or steam
• Scope 3: indirect emissions from the production of purchased materials, waste disposal, …
• Consider two measures:

• Total emission
• Emission intensity: carbon emissions per unit of sales
Economics.
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Dep var: firm stock return of period t Dep var: firm stock return of period t
Log (Scope 1/2/3 TOT): log of total emission at period t Scope 1/2/3 INT: emission intensity at period t
What hypothesis do the results support?
Economics.
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What relates to divestment?
If the stock returns are affected by divestment, what’s the prediction on stock returns? Is it
consistent with the return effects we saw before?
Economics.
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How should we think about “Green” alpha?
• Green alpha argument is widely used
• Why it may be problematic?
• Market may misprice these characteristics (e.g. Edmans 2011), but it seems less likely now given
there’s so much attention
• Return evidence is mixed: we also see the opposite evidence

• Sin stocks and firms with high carbon emission earn higher returns
• Constraining the portfolio in any way should lead to underperformance

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Summary
• Social preference
• ESG investing
• Pecuniary reasons
• non-pecuniary motives
• Institutional restrictions
• ESG investing and stock returns:
• Risk premium
• Value of firm’s ESG investments and market efficiency
• Non-pecuniary motives
• Institutional restrictions: neglect effect

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1

Behavioral Finance (FIN 550E)

Integrate these findings into the market ➝

• Social Preferences: Introduction

• Simplified model of preferences of self when interacting with others:

• What do the following cases capture?

87% of the companies on this list provided a "monetary bonus"

• Different investors state very different goals

• Moral (Non-pecuniary, social preferences)

• Some specific attributes

• More commonly using an aggregate rating

• Environmental, Social and Governance (ESG)

Employee satisfaction and equity prices

• Employee satisfaction can benefit shareholder through two mechanisms:

• Measuring employee satisfaction:

Employee satisfaction and equity prices

Dep var = the portfolio return of companies on the ”Best

What does the positive abnormal return indicate?

Employee satisfaction and equity prices

1. Market is not aware of the BC list

Full Sample Period (1984-2009) Salient-info Period (1998-2009)

The Effects of Social Norms on Markets

• Who owns these stocks?

The Effects of Social Norms on Markets

The Effects of Social Norms on Markets

Dep var: the return of sin stocks – comparable stocks

the initial publication of the

X-axis: globes (sustainability rating)

Survey on MBA students and on subjects from Mturk

Do Investors Care about Carbon Risk?

• Compensation for carbon risk  “risk premium” hypothesis

• Market underprice carbon risk  “alpha” hypothesis

Do Investors Care about Carbon Risk?

• Consider two measures:

Do Investors Care about Carbon Risk?

What hypothesis do the results support?

Do Investors Care about Carbon Risk?

How should we think about “Green” alpha?

• Green alpha argument is widely used

• Why it may be problematic?

• Return evidence is mixed: we also see the opposite evidence

• Constraining the portfolio in any way should lead to underperformance

• ESG investing and stock returns:

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