(Photo by iStock/SasinParaksa)
Financial markets run on the often-unspoken assumption that human beings make perfectly rational decisions that drive capital to the highest-performing enterprises. Indeed, the finance field promulgates an image of dispassionate investors who tirelessly comb through opportunities and seamlessly integrate information to optimize their portfolios.
This hyper-rational ideal does not reflect reality. Evidence shows that systemic biases in investor decision-making lead to costly misjudgments. In the realm of investing to achieve social and environmental impact, definitions of performance are often more ambiguous and information less complete than in traditional investing. Emotions come into play in new and complex ways. These cognitively challenging factors introduce new biases that can lead to misjudgments.
Building on the principles of prior decision-making research, we and others have begun to study biases that affect impact investment decisions and how they might be overcome. Here we offer some observations and recommendations based on academic literature, conversations with practitioners in the field, and our own research.
The Dark Side of Warm Glow
Think about the moment when you were first inspired to become involved in social impact. Maybe it was while reading through the profiles of low-income entrepreneurs seeking support on a crowdfunding platform. Perhaps you watched an inspiring video about a social enterprise or impact-oriented business. Almost certainly, you were drawn in, at least in part, by the feelings you have about making a difference. These pleasant, fuzzy feelings we associate with doing good are what decision-making researchers call "warm glow."
Warm glow is essential to impact investing–it is the cognitive basis for why we are interested in doing good in the first place. But warm glow can also lead impact investment decisions astray. This is because its cognitive rewards are based on acting on our good intentions, not the impact that those actions produce. Because our experience of doing good does not perfectly mirror the impact that they produce, warm glow often leads to decisions that create some positive impact, but not as much as they could.
For example, one of our recent research studies compared how customers of a ridesharing platform responded to two types of promotions. The first offered a cash discount. The second offered a charitable donation to be made on the customer’s behalf. While customer response to discount-based promotions grew rapidly as the size of the discount increased, response to charity-linked promotions increased much more slowly as the size of the donation increased. This is consistent with the "warm glow" phenomenon: Customers received warm glow from the mere act of giving, largely irrespective of the magnitude of help provided, as represented by the amount of the donation. In another study, participants were allowed to allocate a certain amount of money across a set of charities—which varied in the actual impact per dollar received—however they wanted. Most gave small amounts to many charities, which allowed them to receive the warm glow associated with each individual act of giving. However, they would have maximized their impact by focusing their giving on the most effective charities.
Enterprises and funds seeking impact investment can enhance warm glow through storytelling, which research shows to be more effective than presenting objective data. When impact investors respond to such appeals, the outcome can be satisfying, but superficial: Investors feel good about helping the world, while enterprises and funds avoid the costly headaches of collecting and analyzing data on outcomes. But this effectively rewards those enterprises that excel at creating good feelings. To counter this phenomenon, impact investors must always ask if warm glow might be clouding their evaluation of impact performance.
Framing and Reference Points
Another potential hazard is the presence of “frames,” or ways of presenting information. By selectively highlighting certain features of investment opportunities, frames can inadvertently distort investors’ assessment of those opportunities. This can lead impact investors to overlook or misevaluate investments that are objectively attractive for meeting their actual investment goals.
The prevailing frames in impact investing rely on specific, financial reference points. This leads to descriptions of investments as either non-concessionary (having financial returns at or above the market benchmark for risk-adjusted financial returns) or concessionary (having financial returns below the market rate). This distinction has been a flashpoint in ideological debates, with even Bono chiming in to call concessionary investments "bad deals done by good people."
Frames such as these are misleading because they draw overly stark distinctions between investments that are near the reference points on which they are based. An impact investor’s ability to meet their investment goals will not depend much on the tiny difference between an investment that produces slightly above-market returns (non-concessionary) and one that produces slightly below-market returns (concessionary). But framing investments in this way can lead to thinking about such investments very differently.
An even greater risk is that frames based on financial reference points rather than social impact will attract disproportionate attention to financial outcomes, possibly at the expense of attention to social impact. This can lead impact investors to overlook investments that perform well in terms of solving social problems but provide below-market nominal financial returns. As one Impact Alpha editorial observed, the use of frames based on financial returns implies that "good intentions are enough, while good returns are great."
What if the primary way that impact investments were described was as “high-poverty stakeholder” versus “low-poverty stakeholder,” or as “high-carbon emissions” versus “low-carbon emissions”? Frames focused on impact rather than returns could also bias our judgements to focus disproportionately on these factors. Our point is that any framing based on a limited number of factors and reference points can profoundly bias impact investment decisions.
Despite its hazards, framing plays a role in helping us make sense of a complex world and in mapping the field. Certain financial reference points can be legitimate when they align with investors’ particular investment theses and fiduciary obligations. But impact investors should make sure they choose investments based on their real expected outcomes, not how these outcomes are framed.
Thinking Across the Boxes
In pursuing a blend of both social and financial returns, impact investors encounter an unusually broad spectrum of types of enterprises, from pure for-profits to charities to hybrid firms. This complexity makes it difficult for them to create optimal investment portfolios.
We explore this issue in our most recent research, which investigated how people create impact investing portfolios that combine these types. Specifically, we were interested in these portfolios’ outcome-efficiency: Did the chosen portfolio achieve the resulting financial payback and social benefits at the lowest feasible cost? In four experiments, more than 1,600 participants were given real cash to allocate across three options: a for-profit (only financial returns), a charity (only social benefits), and a social enterprise (a combination of both financial returns and social benefits). A large fraction of the participants—between one-third and two-thirds—failed to select an outcome-efficient allocation. This pattern held even for participants who were well educated and financially savvy.
Why did these individuals fail? It turns out that a critical factor is categorical cognition—a tendency to use simple categories, rather than systematic calculation, to evaluate options. We tested this by giving a random set of participants the same impact investment exercise, but with the options presented without the common categorical labels of for-profit, charity, and social enterprise. By removing these labels, this intervention removed the distraction of categories, allowing people to pay more attention to the actual outcomes. With categorical labels removed, participants failed to choose an outcome-efficient allocation far less frequently; in some versions of our study, the failure rate dropped by nearly half.
To summarize, impact investors are called to invest across categories of investments. In the process, they are often influenced by the way these categories are defined. This categorical cognition can only be overcome through careful attention to data on outcomes.
Awareness of Bias Isn't Enough
Impact investors are generally smart, compassionate, and thoughtful, but, like all of us, they are also susceptible to misjudgments. Evidence from other fields suggests that awareness of bias can help reduce its effects, but is unlikely to eliminate them entirely. To go further, impact investors should take the following steps.
1. Build, use, and promote evidence of impact. Former US Supreme Court Justice Louis Brandeis once explained that transparency was needed to fight corruption, writing that “sunlight is said to be the best of disinfectants.” We can think of the collection of credible data about impact as playing a similar role in rooting out bias in impact investment. Without objective, reliable evidence of impact, refocusing decisions on actual impact is difficult, if not impossible.
Despite some progress, evidence of impact is measured less thoroughly and less rigorously than financial performance. Changing this will be difficult but is necessary. To take this journey, impact investors will need to provide financial and technical support to their portfolio companies, which must play the central role in collecting such evidence and ensuring it is reviewed by outside parties.
Higher-quality evidence of impact will enable better decision-making and provide an objective basis for identifying and minimizing bias. Proponents of “effective altruism” and fundraising platforms like GiveWell have made significant progress in advocating for such approaches in strategic philanthropy. Impact investors who commit to evidence-based impact will be similarly empowered.
2. Make complete and specific comparisons. Having built evidence of impact, an important next step is to limit the influence of framing on investment decision-making. One way to achieve this is by comparing investment opportunities to specific investment alternatives rather than to abstract standards such as “concessionary” or “non-concessionary.” While such frames may focus on one dimension, such as financial returns, such comparisons should be made on all of the dimensions relevant to the investment thesis.
In other words, impact investors should ask: If we didn’t make this investment, what would be the specific alternative use for our capital, and what are the expected financial, social, and environmental returns of that alternative? Are tradeoffs on one dimension required to meet specific goals on the other? In this way, investors can consider investments in the context of their full opportunity cost.
3. Look past the labels. Avoid the temptation to use categorical labels to judge whether an investment opportunity fits within your portfolio. Categories like “social enterprise” and “impact business” have murky boundaries, and each might contain opportunities with very different financial and impact outcomes. We are surprised to see how strongly some investors respond to such labels. For instance, some refuse to work with any company that calls itself a social enterprise while others only consider social enterprises.
Investments should be defined first and foremost by the outcomes they produce. By dropping the labels, impact investors can focus more fully on how the underlying investments’ real outcomes can help them to achieve their investment goals.
A Decision Architecture Approach
While the tools outlined above are useful for individual impact investors, it is unrealistic and impractical to expect every investor to employ these strategies, especially as the field continues to grow and become more mainstream. Creating better impact investing decisions will require not only individual action, but field-level efforts.
Fortunately, impact investment decisions are rarely made by individuals in isolation. Intermediaries—such as advisors, information services, platforms, and fund managers—shape the ways in which impact investing decisions are informed, framed, and aggregated. In this way, this ecosystem of intermediaries has a profound influence on the “decision architecture” for impact investing.
This influence creates an important opportunity to “architect” impact investment decisions in a way that acknowledges impact investors’ biases and seeks to diminish their effects. Design of decision architectures also needs to respect and protect individual choice, a principle that Cass Sunstein and Richard Thaler call “libertarian paternalism.”
Consider Kiva, the online microlending platform. It has faced the inconvenient fact that its retail users are typically more responsive to heart-warming stories than nuanced evidence of impact, which do not always go hand in hand. To shift its portfolio towards greater impact without alienating its users, Kiva has started to use published research to identify lending practices and products with the greatest impact potential. It now presents these options more prominently in its user interface. This new approach subtly nudges users toward the opportunities most likely to drive impact while still offering them choice and retaining the story-based experience they favor.
We hope and expect that many investors, both individual and organizational, will deliberately build behavioral insights into their decision-making strategies. Furthermore, as the field continues to expand, the time is right to build systems that incorporate these insights. Even seemingly minor nudges designed by impact investing leaders will have the potential to tilt the growing field toward better financial and social outcomes.
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Read more stories by Matthew Lee & Jasjit Singh.