On Mind: Human-Centered capital allocation and investment decisions
By: Jorge Luis Rodriguez Haro
Tags: Risk, Impact Investing, Finance, Generations

It seems that the times are calling for a global shake-up in how we invest. A vicious pursuit of monetary profits only is gradually losing relevance. Profit and interest are human-made notions that can only sustain themselves if they improve our livelihoods.

Investors are increasingly aware and active. As market participants’ mindsets shift, the power of investment decisions to direct entire populations’ faith is evident. Younger generations, raised with a greater social and environmental consciousness, are gaining weight in investment decision-making[1]. As evidenced by the chart below, published in a recent The Economist article, younger generations are still due to gain “voting power” in financial markets. Yet, they are bound to gain much more in the coming years.

This change in financial market demographics comes at a time of increased evidence of stress on global resources. Therefore, investors are bound to assess if their investments improve people’s living standards while keeping the planet safe, going beyond trickle-down economics.

Even previous’ generations decisions come under the spotlight as we assess whether human dignity is at odds. We are now observing whether and how countries tax their citizens with limited or precarious access to basic services due to poor policymaking and corruption.

Consider Latin America, a highly urbanized continent where people in most countries may be affected by a lack of or inadequate access to essential services. How much have past capital allocation decisions impacted our current situation? Yet, even more relevant, what investment decisions can we execute now to improve livelihoods and potentially reverse any damage inflicted?

Beyond past investment decisions, there are demographic, cultural, and institutional aspects to consider. However, focusing on our capital allocation decisions: how much did we consider the long-term risks and externalities of investments? Did we consider the effects of illegal or unplanned urbanization, a disorganized expansion of public and private transportation systems, and a failure to attract more infrastructure and education investment? Can the current state of the system be corrected, and how much creative destruction will be necessary to do so?

Capital Allocation and investment decisions ultimately come down to balancing risk and return expectations. As markets’ feedback loops become faster for risks but less so for returns, we must incorporate into our decision-making effects only observable in the long run. Furthermore, market swings will evidence broader definitions of risks and returns.

By embracing delayed gratification of our investment decisions, we would aim at maximizing economic value, defining economic value as a by-product of value for all stakeholders. On the other hand, a focus solely on short-term profitability, while enticing, may bring as by-product precarious standards.

Risk perspective

From a risk perspective, a way of incorporating sustainability is by modeling business interruption within projected operations. These may come either through declines in demand, which in turn may be driven by reputational factors or loss of relevance in consumers’ choices; or through increased cost pressure, due to value chain interruptions or resource depletion, for example.

Of course, it’s up to us to understand the factors that may trigger those interruptions and the transmission mechanisms to our business. Once we play around with the possibilities through different scenarios, we will readily understand our investment decisions’ implications.

The risk perspective is where the financial industry at large is already evidencing significant advances. Through investment managers increasingly widespread adoption of heightened Environmental, Social, and Governance (ESG) standards for themselves and their portfolio companies, there is a marked movement towards a more holistic evaluation of investments.

Return perspective

There is still a gap to close from a returns perspective. Despite the increased interest in impact investment, expanding beyond public or multilateral development finance institutions (DFIs), there is still room to develop and incorporate to decision-making variables beyond financial sustainability.

The UN SDGs serve a great purpose in providing direction, while the GIIN[2] offers an excellent framework to measure impact through its IRIS+ system. However, there is still no consensus on impact measurements to adopt, and many impact investors adopt in-house, though well developed, measures to follow their investments.

This situation still leaves room for uncertainty among companies, especially in earlier stages. However, as investors demand heightened standards, these companies may be increasingly pressured to incorporate impact metrics in their reporting. Some impact investors perform hand-holding with their investment targets regarding impact measurement. However, a chicken or egg situation presents for companies in sectors different from these investors’ strategic focus.

In my view, companies at an early stage should focus on their purpose, business model, and scaling valuably rather than on measuring impact. Given the amplitude of impact measures used by investment managers and investors, it is counterproductive to dedicate resources to finding the metrics that will please most of them.

As with any return measure, investment managers are most interested in their investments’ marginal effect over impact variables. Therefore, it’s best to rely on their preferred criteria, as objectives will differ among investment managers and the investors they represent. If an investor fits to support a company’s growth, its impact frameworks will serve the company.

All investment decisions are based on risk and return expectations. However, the success of those decisions is only measured once the investment produces liquidity. As people’s definitions of success shift beyond variables reducible to monetary terms, their definitions of success in investments will likely shift as well. Market participants, including investment managers and companies raising capital, may be affected by a shift in investors’ profiles and objectives. Maintaining an open mind and creative approaches for investment evaluation is a crucial complement to their practices. I hypothesize that the adoption mechanism of broader standards, at least for returns analysis, will come first from private markets. The question remains on whether we are on the brink of the widespread and rapid adoption of new forms of evaluation or if the change if it occurs, will be gradual.

[1] The economist recently published a series of articles on the increasing power of younger generations, evidencing the shift that is already occurring https://www.economist.com/finance-and-economics/2020/10/20/wall-street-will-soon-have-to-take-millennial-investors-seriously