Integrating Sustainability Into Portfolio Selection With Risk‐Utility Profiling

ABSTRACT Modern portfolio theory (MPT) traditionally focuses on the risk–return trade‐off, often overlooking investors' sustainability preferences. This paper introduces a unified portfolio‐selection framework, which we term green portfolio theory (GPT), integrating environmental, social and governance (ESG) considerations alongside classical risk aversion. We calibrate investor preferences for risk, return and sustainability using an extended profiling instrument, then embed these parameters within a single objective function that jointly evaluates expected return, risk and ESG impact. Individual absolute risk aversion ( λ ) is determined using the Arrow–Pratt measure of absolute risk aversion. The resulting optimisation yields a three‐dimensional efficient frontier, illustrating how varying sustainability weights modify optimal asset allocations. Empirical illustrations demonstrate that investors with stronger ESG preferences tend to accept modest reductions in expected return, with the marginal rate of substitution between risk, return and sustainability determined by individual preference parameters. We also propose a coupled utility parameter SHAIRP (specific Hamilton adjusted impact return preference), that quantifies the return ‘sacrifice’ investors are willing to make in order to achieve a concrete sustainability improvement and this is loosely derived from W. D. Hamilton's work on kin selection in evolutionary biology and genetics. Our framework provides a practical methodology for constructing portfolios that align financial objectives with ethical imperatives and enables asset managers to design investment products in accordance with emerging regulatory requirements for responsible investing. By extending traditional MPT to account for sustainability, we offer robust guidance for investors and advisors navigating the evolving landscape of sustainable finance.