A Theory of Profitable and Effective Socially Responsible Investments

We examine the functioning of financial markets when firms can invest in activities that produce externalities. We consider a model in which some investors are socially responsible in the sense that they take externalities into account when they value their portfolio. We study two issues: i) under what conditions do firms adopt a pro-social behavior (i.e., limit negative externalities or expand positive ones), and ii) how does the financial performance of socially responsible investors compare with the one of convetional investors? There are two mechanisms by which socially responsible investors can inuence firm’s decisions. They can vote with their feet, shying away from “vice” firms, and thereby raising their cost of capital. Being relatively more invested in pro-social firms, socially responsible investors have a lower risk adjusted performance. Socially responsible investors can also engage in activism. A large investor can generate positive abnormal returns by investing in non-responsible companies and turning them into responsible. In some circumstances, a long-term horizon and a pro-social orientation raise the purely financial profit of the large investor.