Maximising Outcomes in Impact Investing

We define an “outcome-efficient” allocation as a decision that lies on the efficient frontier, i.e. realises one of the best possible combinations of financial payback and social benefits feasible for the given amount of money. In our experiments, a large fraction of individuals – between 33 and 62 percent, including many participants who were well educated and financially savvy – systematically failed to make optimal allocation decisions.

Our last two experiments explored whether the observed failure to achieve efficiency could be attributed at least in part to “categorical cognition”, a tendency to make decisions using heuristics based on known categories rather than full analysis of relevant data. We found that removing labels – “social enterprise”, “charity” or “for-profit” – from investment options led participants to make better decisions; outcome-efficiency was higher in all the “no labels” groups compared to their respective control groups. For example, in the final experiment that involved MBA students as participants and an endowment of US$20, only 9 percent of people in the no-labels group chose inefficient options, compared to 31 percent in the with-labels group.   

Our paper, published in Strategic Management Journal, is one of the first academic studies to document the cognitive challenges inherent in impact investing decisions. The paper builds on related research showing that the choices individual donors as well as retail investors make might often be inefficient due to cognitive biases, like the “warm glow” one gets from altruistic actions (regardless of actual outcomes). We show that such human tendencies to use heuristics, including thinking in terms of categories, can also get in the way of making effective decisions in impact investing and venture philanthropy.

Making better impact investing decisions

Ensuring that impact investing and venture philanthropy realise their full potential certainly requires continued improvement in how we measure impact in the first place. Promising efforts in this direction are already under way – both at the organisational level (such as Root Capital employing a version of the efficient impact frontier framework) and at the ecosystem level (through initiatives like B Impact Assessment and the Impact Management Project).

But making progress on impact measurement alone would not be sufficient. Investors need more support in making effective decisions. This will involve getting them to both care about and understand the real impact their portfolios could achieve. Reaching this goal requires a combination of investor education and behavioural nudges to help overcome decision-making biases.

More broadly, rather than considering concessionary vs. non-concessionary investing as competing ideologies, we should think of them as complements. Which one is the better option depends on the particular context and venture stage. And sometimes bringing them together as a “blended finance” arrangement can realise overall impact greater than the sum of the parts.