ESG Investing and its Impact on Risk-Adjusted Portfolio Returns from a Behavioral Finance Perspective Using SEM

Abstract

The prevalence of Environmental, Social, and Governance (ESG) perspectives in investing and portfolio construction focuses on potential long-term impact and risk, which has led ESG investing strategies into portfolio management. The study addresses the question of whether ESG investing strategies produce risk-adjusted returns, especially with the presence of investor behaviour and psychological biases. ESG investing strategies, herding behaviour, and bias in cognition are aspects of behavioral finance. The main goal is to address the structural correlations in ESG investing, Behavioral Finance, and portfolio management. Direct and indirect effects of independent variables are investigated by Data Analysis using the SEM approach. The model takes ESG investment intensity as the exogenous variable; constructs of behavioral finance as mediating variables; and, as the endogenous output variable, risk-adjusted portfolio returns measured in terms of Sharpe-like performance efficiency. The empirical evidence shows that ESG investing has a positive, statistically significant impact on risk-adjusted portfolio returns, meaning that portfolios with ESG tend to deliver performance that is better sustained across different market conditions. Additionally, the behavioral finance factors mediate the relationship at least partially, and investor biases and sentiment reinforce the ESG investing effects. Overconfidence bias moderated the degree to which portfolio efficiency was gained, while risk perception and herding behaviour were found to amplify performance effects tied to ESG. The SEM (Structural Equation Model) results validate the proposed conceptual framework and confirm both the model’s effectiveness and the degree of plausibility. ESG investing for the given study not only improved risk-adjusted returns in a portfolio but also offered behavioral insights valuable to institutional investors and portfolio managers in improving their investment approaches for rapidly changing financial markets.