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Do Behavioral Finance and Impact Investment Make Good Bedfellows?

Aug. 16, 2013
Investing, Investments
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Vital Capital Fund is a private equity fund that invests in communities and families in developing African countries. It expects to have at least market-rate returns on its investments. Even though many impact investors like Vital Capital promise market-rate or near market-rate returns on their investments, many mainstream investors are still wary of impact investing. How can impact investors make their funds or products more attractive to investors? Should impact investors seek to make their funds and products more attractive?

The answer might lie with behavioral finance, but before we get started, it makes sense to first brush up on some behavioral finance and impact investing basics:

What is behavioral finance?

Behavioral finance integrates cognitive and behavioral psychology with economics and finance.  Before the advent of behavioral finance, most economists and investors subscribed to the efficient-markets hypothesis, which assumes that all market participants are rational, wealth-maximizing actors. In the real world, investors often engage in irrational behaviors and behavioral finance uses aims to explain those irrational actions.

Some investors have sought to apply behavioral finance principles to their investing strategies. They seek to find assets that are mispriced because of irrational tendencies such as following crowds or overreaction to market fluctuations.  The effectiveness of behavioral finance investment strategies, however, is still being determined.

What is impact investing?

Like behavioral finance, impact investing is a combination of two ostensible opposites: finance and philanthropy. Through their investments, impact investors hope to create measurable social, environmental or cultural change and preserve capital or make money as well. Unlike traditional investments, impact investments have both impact goals and financial goals. Unless an investment achieves both goals, it will not be considered successful.

How do the two go together?

For both impact investors and traditional investors alike, behavioral finance can help minimize the overestimation or underestimation of risks. Impact investors can use behavioral finance principles to better manage their expectations, especially since they must juggle both their impact goals and their financial goals. Impact investors can use behavioral finance principles to better market their funds and products to attract traditional investors.

Behavioral finance might also play a role in some impact investors’ investment strategies. Some impact investors believe that because they have different metrics for evaluating assets, they will be able to find mispriced assets that traditional investors avoid. For example, a traditional investor might avoid investing in a low-income housing development, even if the investment promised to be profitable, because it just seems like a bad investment. An impact investor, on the other hand, would not be affected by the irrational hang-ups possessed by traditional investors.

So, what role does behavioral finance play in impact investment? NerdWallet turned to experts for their opinions:

  • Professor Hersh Shefrin, Mario L. Belotti Professor of Finance at Santa Clara University, believes that behavioral finance principles will help those interested in impact investing make better decisions:

NerdWallet: How do you think innovations in behavioral finance can help the expansion of impact investment? How do you think behavioral finance helps to find the best asset for impact investment?

Hersh Shefrin: This pair of questions pertains to three behavioral concepts: familiarity, framing, and fear. These 3Fs are germane to those investors with a genuine interest in having their investments create social value but who refrain from impact investing because they form excessive assessments of the risks involved. As regards the first question, the short answer is by making impact investing feel familiar, by framing the activity to emphasize similarities with other types of investing. To the second, by seeking areas where unwarranted fear has led other investors to shy away, and not look deeper for opportunities to create social value, if not financial value. That said, there is a Goldilocks issue here, about finding a bowl of porridge of just the right temperature, not too hot and not too cold, but just right. Seeking is not the same as finding. Behavioral studies warn us that some impact investors will underestimate the risks of impact investing, just as others overestimate the risks.

NW: Do impact investment principles make asset classes deemed risky by traditional finance more palatable for impact investors?

HS: Yes, because the opportunity to create social value augments the financial return, a factor often neglected by the traditional model. For a genuine impact investor, the creation of social value can compensate for lower returns, although the degree of compensation so required will vary from investor to investor.

NW: How can behavioral finance help explain differences between traditional investment strategies and impact investment strategies?

HS: By emphasizing the social value component to the investment, that return and risk involve more than dollar returns and volatility.

NW: How does behavioral finance affect the notion of risk with regard to impact investment? In other words, how is risk viewed when making impact investments as opposed to traditional investments?

HS: In the behavioral framework, risk is only partly about volatility. It’s also about the probability of missing goals, whether financial or social. And goal setting gives meaning to what impact investment is all about.

  • Professor Meir Statman, Glenn Klimek Professor of Finance at Santa Clara University, believes those arguing that behavioral finance will help impact investors locate mispriced assets are misguided:

NW: Do impact investment principles help portfolio managers find mispriced assets or deals that traditional investors might not find?

Meir Statman: I don’t see it that way. I think that there is quite frankly too much wishful thinking and hypocrisy, if I may say, that goes on in the impact investing community. It is really kind of parallel to the notion that you have to manage charities as businesses and you have to find the internal rate of return, which is both baloney, as well as uncaring and unfeeling.

When you help the environment and lose money in the process, well you get a warm glow. I think there is a tendency to underplay the tradeoff that goes between money and warm glow. I think that is too bad. I have been talking about the notion of the alpha-seekers. I think too many of the money-managers have in fact corrupted the socially responsible investing community by promising that not only will they do good, but they will have high returns. Eventually they will get low returns and it will be the money managers that will get the high returns through fees.

Impact investors should not expect to get high returns and shouldn’t expect that there are some profit-seekers that there are who are so stupid that they don’t see it. The profit seekers of Goldman Sachs, and so on, are pretty sharp. If there’s something that could make them money, they don’t care if it’s socially responsible—that would be nice—but they couldn’t care less. The idea that there are some investments out there that are really profitable and that only the social impact people can see them is being unrealistic.

NW: We’re talking a lot about the alpha-seekers diluting impact investing. What do you think about the idea that they are necessary to attract retail investors and capital?

MS: That is really what is wrong. I think of the impact investing as something that used to be a pretty small church. It actually started from a religious movement. Now when I say that the industry has been captured by the alpha-seekers, it’s actually expanded the church by weakening it. Like, ‘Oh, you can just come on Yom Kippur or Easter. No big deal, you don’t have to keep kosher, you don’t have to give up anything during lent. Just come as you are.’ I think that this really is more a burden than a benefit. I think it is better to come to people honestly and say this is a case where you are going to get lower returns, but you are going to do good for others and you will be happy with it. If I give money that gives interest free loans to the poor, I’m going to get zero return and probably negative returns if they do not pay back. This is not the way for me to make top dollar.

NW: Do you know any impact investing funds that use behavioral finance ideas in models?

MS: No. I’ve seen some funds that tried to do that. I don’t even want to mention names. I just don’t think much of them. You expand it to the retail investor, but you expand it in ways that are not befitting of anyone who—I don’t know what you call it—just plain honest.

  • Professor Terrance Odean, Rudd Family Foundation Professor of Finance at Berkeley’s Haas School of Business, does not believe behavioral finance principles will aid impact investors:

“I have not previously thought about the implications of behavioral finance for impact investing. No significant implications occur to me. Obviously risk and reward are more complicated for an impact investor since she perceives the potential positive impact of her investments as a reward and also perceives that the companies she invests in may help mitigate risks borne by society. Thus both risk and reward have monetary and social welfare dimensions.

 “While impact investing will differ from traditional investing in strategy, I don’t see the behavioral side as first order. Secondary considerations might be that people focus on particularly salient or available impact investing opportunities which are not necessarily those with the most potential to effect positive change.

“I doubt that impact investing will significantly reduce overconfidence or crowd following. The crowd will change as might the beliefs about which one is overconfident. While I understand the desire to buy stocks in companies that are doing good, small purchases of stock in secondary markets will not dramatically affect most companies’ cost of capital. Some small impact investors may be overconfident about the impact of their investments.”

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Rich and Poor United photo from CreativeCommons