SRI/MRI and the Philosophy of Risk/Return – Part 2

I was excited and somewhat scared to know that my last post was picked up by Sean on Tactical Philanthropy:

Tony Wang, who assisted Paul Brest and Hal Harvey with the Mission Related Investing section of their book talks about how he sees much MRI work having little to no impact. His most salient point is the idea that if an MRI opportunity offers a market rate of return, non-social investors will fund it and so there is no impact available to social investors.

I have no idea if Paul and Hal are cool with me blogging – and I’m also a bit surprised at how my position was summarized, since I’m actually a proponent of the MRI movement, especially in investments that make market rates of return or better (partially because of my previous worry of combining philanthropy with business transactions that generate below market rates of return). To clarify, my point was largely that investors have different perceptions of risk and return that cause market inefficiencies for companies that can generate both market rates of return and social impact – and that the greater the inefficiency, the greater the social impact.

Let me return to the Omidyar example. Let’s say I’m Omidyar and I’m considering an investment into Digg, both for its competitive market rate of return and social return. I know that if I don’t invest in Digg, other investors will. Thus, because my valuation is the same as for-profit investors and there are other investors that are willing to invest in the company if I don’t, the social impact of my investment is negligible; compared to the counterfactual (i.e. the state of the world if I don’t invest) the social return on my investment is little to none (and possibly negative if instead, I would have used those funds for grantmaking instead).

But let’s say I’m New Cycle Capital and I’m considering an investment into SneakerVilla, also for its competitive market rate of return and social return (there’s an interesting article by BusinessWeek that profiles SneakerVilla’s good performance during the economic downturn). And let’s say that I know that if I don’t invest in SneakerVilla, traditional for-profit investors won’t either because they don’t think it can generate competitive market rates of return. In this case, because my valuation is different than traditional for-profit investors, my capital makes a difference. Thus, when I compare my decision to invest versus the counterfactual, the social return on my investment is equal to the social impact generated by Sneaker Villa.

So, to reiterate, social investors seeking market rates of return have social impact when their valuations of companies are different and their supply of capital matters.

To tie this back in with the efficient market hypothesis, I wanted to discuss a little bit about the underlying philosophy behind risk and return. In the case of flipping a coin, I would know that 50% of the time the coin will come up heads while the other 50% of the time, the coin will come up tails.

However, we say that a coin has a 50% chance of coming up one side or the other given the information we have at the time. If I know which side is facing up at the time the coin is flipped, the initial velocity of the coin, and the initial distance from where the coin was flipped and where it will land, I might be able to predict, with greater accuracy, what the probabilities are of the coin coming up heads or tails. In fact, philosophical determinism suggests that everything in the world can be predicted if you know enough about the world in the past, which means that given sufficient information, I would be able to predict with 100% certainty whether a coin flipped would come up heads or tails (watch Paycheck starring Ben Affleck and Uma Thurman for a good illustration of the relationship between prediction and determinism).

So what does this have to do with investing? Well, like in the coin flipping case, some people might have false beliefs about investing and get lucky (which is what many economists, many of whom are bitter that they haven’t been financially successful, claim is the case with Warren Buffet). My mom is a perfect example of this – although she watches Nightly Business Report and Investing with Rob Black on a daily basis, I’m not so sure whether her investment philosophy is correct, because her reasoning is somewhat suspect (though she continues to outperform the market to this day).

But in other cases, sometimes investors have more information and/or better analysis that leads them to beat the market. Like in the case of coin flipping, if I have relevant information about an investment opportunity and can understand the causative relationship between those factors and the company’s future financial performance, then I can “beat the market.” In the case of New Cycle Capital, I think they may actually have more relevant information about their investment opportunities and/or less bias than traditional investors that enables them to predict, with greater accuracy than other potential investors, the actual risk/return valuation of SneakerVilla.

However, I would like to point out that conducting analysis on the basis of ESG factors alone may not be correct. Stay tuned for another post on investment screens and an excerpt from The Market for Virtue by David Vogel.