Impact investing may be relatively new field, but behavioral economics is not. The discipline was articulated in the late 1970s by Richard Thaler (with the help of a few psychologists) who noticed that even his colleagues did not always adhere to the rational decision-making processes they preached. After years of exploration he found that human decision-making is not really rational at all, but driven by emotion, framing, and a million outside influences.  (For a list of great books to read on the principles of behavioral economics, see below).
I’ve been exposed to these theories in action in policy making, marketing, consumer research, and public health, so when I started studying and working in the field of impact investing, I was curious to see what behavioral theories could be applied to the field.
An obvious one is the “optimism bias.” Behavioral economists have found that people tend to overestimate their chances of success and underestimate the potential for loss or failure. It is this bias that many say was a driving force behind the risky investments made in the mortgage and financial markets that led to the global economic downturn. Remaining conscious of this bias is important for impact investors – especially those working in emerging and frontier markets – as they juggle numerous risks that are rarely in their control. Effectively understanding and absorbing these risks into investment considerations will help impact investors avoid their natural tendency to see potential investments through rose-colored glasses (which become even rosier when coupled with compelling impact stories).
Another theory that is particularly relevant is the effect of “framing and anchoring.” Impact entrepreneurs typically have to raise multiple types of capital to launch and grow their businesses, forcing them to live in a grey area between the philanthropic and venture capital worlds. Unfortunately, the source of capital an impact entrepreneur attracts in the beginning of their fundraising process leaves a lasting impression on future investors. Entrepreneurs who receive grants to help build their business plan and refine their model may be unattractive to traditional equity investors when they go to raise growth capital. The “subsidy” smell lingers and frames the business as mission-first or mission-only and thus unattractive. It works in the reverse as well. Entrepreneurs who get seeded with angel or venture money often have trouble receiving grants down the line because they “sold out” early on and went with the commercial option. Philanthropists may see them as “financial first” – AKA mission-light – and shy away from providing the grant capital needed.
Rockefeller Philanthropy Advisors explores these concepts and more in the behavioral finance section of their report “Solutions for Impact Investors.” They conclude: “we see a clear role for behavioral finance in impact investing, particularly in how aspects of behavioral finance can help investors articulate and better frame their impact investment theses. In some cases, impact investing can even be viewed as correcting behavioral finance biases, which traditional market mechanisms are not addressing. By being cognizant of our biases, and on the look-out for potential market failures, the impact investor can invest both more prudently and create more positive social and environmental impact.”
These concepts make a lot of sense for direct investors, but are there additional field-building applications? How do we get more of the world’s capital to address impact in addition to financial return?
This summer, I worked with Calvert Foundation, a nonprofit that raises investment capital from everyday investors in order to bundle and deploy funds to help underserved communities in the US and abroad. A unique quality of Calvert Foundation is that its core product, the Community Investment Note, is available to investors for as little as $20, but more importantly, investors can purchase the Note over the counter through broker dealers and financial advisors. (More than 80 percent of the Notes are sold through this channel.)
What they have found over the years is that financial advisors – as their recent report of the same name implies – are the “gateway” to a large pool of investment dollars. FAs across the US manage trillions of dollars for their individual and institutional clients and they are often the main driver behind how their clients’ assets are allocated (as the popular Hope Consulting Money for Good report confirms).
In order to use impact investing to help solve the world’s largest social and environmental problems, the field needs to attract a much greater pool of assets. Attracting the trillions controlled by FAs – or even a slice of it – is one huge untapped resource that needs to be seriously explored. (And yes, public pensions and endowments are the elephant in the room – but that’s a post for another day.)
What can we learn from behavioral economics to encourage financial advisors to consider these investments? If we break down the process by which financial advisors make investment choices with their clients, most of these decisions are made at three distinct periods: (1) at the time of initial client acquisition, (2) when there are subsequent substantial inflows of capital (inheritance, bonuses, sale of assets), and (3) during periodic portfolio reviews. During all of these conversations, the advisor asks basic questions – they go through a checklist of sorts – to determine the best asset allocation strategy for that particular client. This checklist includes things like risk tolerance, time horizon, family dynamics, estate planning, tax efficiency, etc. – all considerations to understand how to align the client’s portfolio with their life goals.
It turns out that our decision-making is greatly influenced by this list – or form – that the advisor uses. As Dan Ariely explains in his popular TED Talk, forms and the way they are designed have a large effect on the decisions that we make (for a fun, illustrative example, watch the talk – it’s fabulous).
So what if we redesign this checklist to include one more item? What if, in addition to all of the financial considerations listed above, the advisor asks the simple question “is your investment portfolio aligned with your values?”
This question will elicit three likely responses:
(1) “Yes.” There are those – like the LOHAS crowd – who understand and adhere to the principles of “responsible,” “sustainable” investing, and already own SRI/ESG mutual funds or products like Calvert Foundation’s Note in their portfolio. They can confidently say that their investments match their stated impact values. They check that box and move on to the small talk.
(2) “I don’t know.” This population – I’d surmise – will be the largest cohort. These clients may consider themselves conscious consumers in other purchasing realms, but they have never considered the impact of their investment decisions. For these folks, this question will – at the very least – spur a new conversation with the advisor about the socially responsible or impact investing options for their portfolio, getting them a step closer to becoming an impact investor.
(3) “No, I like to keep my finances and my charitable giving separate.” These are the clients who live in the Bugg-Levine/Emerson bifurcated world in which you maximize financial return on your investments in order to give back through philanthropy. While noble (at least they are giving back, right?), it is unlikely that people with this mindset will change their ways, particularly those who have been following this mantra for decades.
Client groups #1 and #3 won’t do much to change the status quo, but the middle group holds great potential. These are the investors and institutions that have not been formally introduced – through their trusted advisors – to the idea that they can leverage their investment dollars to create a positive social and/or environmental impact while still getting a healthy financial return. Armed with new knowledge and concrete options – resulting from one simple checkbox – they will start to see how to marry their investments with their values.
Any attempt to size this new pool of capital would be futile, misleading, and would elicit more responses than I can handle, so I’ll just say this: The gateways to impact report that I mentioned above estimated that, based on financial advisors willingness to explore sustainable/impact investing with their clients, the market potential would be around $650 billion. It is plausible that if this question were asked to all clients – not just those who FAs deemed worthy of the conversation – the size of the pool would exceed that number – and create bottom-up demand for more impact investing products across asset classes.
Regardless of the number, this new pool of capital could have an exciting potential impact on the “end user,” or the people living in poverty across the globe. This new influx of investment capital would cause social entrepreneurs, international development agencies, and nongovernmental organizations (NGOs) to innovate and reorganize to absorb this newly available capital. Social entrepreneurs will have more incentive to find sustainable models, international development agencies will look for more efficient ways to deploy capital, and established NGOs will look for new areas of growth and expansion that can be financed by newly developed debt options available.
I know I may be getting ahead of myself – and I fully understand that this is not a silver bullet for solving global poverty – but if we can move the needle by introducing one simple question, it is worth a try.
What other ways can you think of to adopt behavioral principles to build the impact investing field? I’d love to hear your thoughts and ideas.
Great books on behavioral economics:
· Free Market Madness, Peter Ubel
· Nudge, Richard Thaler and Cass Sunstein
· Predictably Irrational, Dan Ariely
 Free Market Madness: Why Human Nature is at Odds with Economics – and why it Matters, by Peter A. Ubel.
 LOHAS = lifestyle of health and sustainability