How do investor preferences on ESG score influence portfolio management? A Markov model for simulating risk-return expectations

In recent years, the increasing interest in financial policies in more sustainable economics and the consequent growth of public awareness about environmental, social, and governance (ESG) companies’ issues have modified investors’ portfolio management through ESG considerations in investment decisions. Consequently, the classic Markowitz mean-variance solution based on expected returns and standard deviation has been modified to consider ESG firm characteristics. This study investigates how investors’ ESG preferences influence portfolio choices and decision-making processes. We employ a discrete-time homogeneous Markov model to analyze ESG rating migration patterns, simulate possible configurations of the efficient frontier in portfolios aligned with sustainable preferences, and optimize portfolio asset weights complying with ESG portfolio performance over a time period. The obtained results provide a means of assessing the impact of the investor’s propensity toward sustainability over time on portfolio profitability. This approach provides insights into how ESG considerations may reshape portfolio performance over time, fostering more informed and ethically guided financial decisions.