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Theory Behind Decision Making and Impact Investing

This chapter gives an overview of the relevant research and literature on impact investing with a focus on decision-making, as well as the importance of impact analysis and locates any gaps in research so far that this thesis can then address. To accomplish this, journals articles, industry reports and a number of online resources were used.

The various lines of research can be identified as investment decision-making, risk as a factor of investment, moral approaches to investment decision-making and the importance of impact measurement and outcomes including challenges in the field.

Investment decision-making

As impact investment is a moderately new field, there is relatively little academic literature currently available that sheds light on the decision-making processes and the field in general, as such the following review seeks to evaluate literature from the areas of behavioural finance and socially responsible investment, as well as, specifically, investment decision-making in order to analyse the basis for their actions.

Impact investing at its core is still a form of investing, in the principle that expenditure now is made to make future gains or profit. These processes involve an investor or economic agent, as described in traditional economic theory, making calculated decisions factoring in risk, profit expectations, costs and availability of capital (Virlics, 2013). As such, it is important to begin by looking at the literature surrounding the processes involved in economic theory as these provide the basis on how investors approach an investment. One underlying theory behind investment was Markowitz’s Portfolio theory, he proposed this as an explanation and framework used in order to maximise the investors expected portfolio returns, while simultaneously reducing the investment risk. One of the critical proposals is that investors are risk averse and therefore prefer lower risk for any given level of returns (Markowitz, 1952).

The area of investment decision-making theory was then built upon further with the introduction of cumulative prospect theory (CPT). This enhanced expected utility theory and addressed issues from deviating to this model (Kahneman and Tversky, 1979), the model allows the further understanding of agents and how they may behave. CPT specifically focused on how different agents value losses and gains differently and, as such, any decision making is based on their apparent gains. It also allowed the understanding of decision-making under scenarios involving uncertainty (Gurevich, Kliger and Levy, 2009). This is important as when investing, uncertainty is high and there are a large number of outside economic and financial variables that can influence investments. This, in theory, would increase when including some of the additional risk factors involved in impact investing.

However, while these theories allow the assessment of decision-making in investment scenarios, there are a number of large flaws when applying this to impact investing or similar areas, such as Socially Responsible Investing (SRI) (Tobias, Benjamin and Peylo, 2014). This being based on the fact that they assume investment decisions are made both logically, and therefore selfishly. This is because it is implied in traditional literature that having morals, or a moral undertaking, that involving other factors such as social and environmental impact when making investing decisions would introduce inefficiency into the system, reducing the number of investment opportunities. As outlined in Modern Portfolio theory, these moral considerations would either increase risks or lower the overall return reducing its efficiency in comparison to a more traditional portfolio (Markowitz, 1952).

This then indicates that in order to maximise profits, financial aspects should be the only factors to be considered when undertaking investment, that said, this is clearly not the case when it comes impact investing or socially responsible investment of any kind as other factors are also taken into account when making these decisions, such as morals and subjective consensus (Hofmann and Kirchler, 2008). Some Impact investors do acknowledge that while returns are important they accept below market rate returns in order to maximise impact and are willing to accept this as a reasonable trade off (Pomares, 2009).

Influence of the firm on investment decisions

While thus far throughout this chapter there has been a focus on the individual decision-making processes of the investor. It would be wrong to assume that this is the only factor at play, as many firms have several decision-making processes in place in order to maximise performance. Processes such as financial reporting, rational decision making and a wider level of participation in decision making are all linked to improved performance in the long term (Papadakis, 1998).  It could also be assumed due to the importance financial reporting has in improving performance, that increased non-financial reporting could also have a similar effect, while it is also suggested that an increase in non-financial reporting could lead to an overall increase investor support for CSR (Glac, 2008).

Impact investing or SRI also commonly contain screening in order to help in the selection process of assets. While the firm undertakes this process in order to ensure it abides with its socially responsible ethos, these screens could also cause an increase of risk and lower efficiency, through hindrance to diversification. That said, conventional investors also often apply their own screens, for example, minimum IRR etc., with the literature suggesting that portfolios often end up similar sizes (Peylo and Tobias, 2012).

Risk as a factor of investment

Prior to discussing the factor of morals and the part they play in investor decision making there is another key variable to any investment, this being risk. Risk is defined as an agent’s readiness to invest money when outcomes are uncertain (Fehr-Duda et al., 2010). It is also a very important issue when looking at the investment process and is a key part of investment decision-making (Virlics, 2013). A tolerance to risk is, therefore, a key factor and has an influence over many different aspects of financial decision-making. Analysis of these risks also is, therefore, an integral part of any investment decision. This analysis consists initially of an objective analysis of the investment, potential outcomes and returns but also an analysis based on the subjective point of view of the investor. Investments always contain some amount of risk, due to the volatile and fluid financial markets, that said this risk is perceived differently and on a subjective basis involving a multitude of factors include both psychological and emotional influences. Virlics highlights, it is important to examine this from a behavioural economic point of view and not a single objective part, as it is the risk perception that affects the overall decision (Virlics, 2013).

Impact investing adds yet another variable to this problem, as there are a number of other types of risk to engage and analyse, above and beyond financial risk. These factors include; impact risk: the risk that, what may have been view as originally a positive impact turns out to be negative, Measurement and reporting risk: the risk of inaccurate and poor overall assessment of the social or environmental impact created and finally social enterprise risk: considers the likely range of outcomes not just the business implementation and venture type itself (Impact assets, 2014).

Introducing morals

As discussed, there are a number of issues in applying more traditional investment decision theory to impact investing, as traditional theory is based on capital accumulation through the maximisation of utility, this approach does not agree with impact investing as profit at all cost is not prioritised and while the motives of each investor do vary, they are not solely focused on wealth. Variables such as societal impact and the environment hold importance and in some cases dominate the individual financial aspects (Tobias, Benjamin and Peylo, 2014).

It has even been argued that as investors themselves live in the world they invest in and as such are affected by the decision and consequence of the business they facilitate it would be irrational not to include sustainability and therefore impact in decision making (Tobias, Benjamin and Peylo, 2014).

There are a number of models that are have been developed to help explain this moral behaviour including; Multiple attribute utility theory (MAUT), the theory of planned behaviour and the issue-contingent model of ethical decision making (Hofmann and Kirchler, 2008). Hofmann et al. found that investment behaviour was influenced by the utility of morality, intention to invest and the moral intensity of investment more than profitability, this finding that investments are not only guided by economic rationality is of key importance when look at impact investing. It also suggests that social consensus is one independent factor affecting the decision-making process as well as subjective norms, these assumptions are key to explain the trends visible in why and where impact investors are placing their capital.

It is clear then, that it needs incorporating within the impact investing decision-making process, and into the development of impact investment portfolios in order to maximise returns in both impact and returns and minimise risk. Within the literature this has taken place through the characterisation of investments into three parts, risk, return and impact with the impact measured through screening processes (Saltuk, 2012). Another approach taken was in the area of SRI through the synthesis of Prospect theory to include CSR characteristics and using a three-dimensional optimisation, by doing this the process improved and CSR criteria is not just used for the screening process but also in maximising the performance of the portfolio in terms of impact (Peylo and Tobias, 2012).

Metrics and impact measurement and outcomes

Social innovation impacts and outcomes, unlike technical innovation, cannot be measured initially by market growth profits or customer’s approval (Antadze and Westley, 2012). As such, one factor involved in allowing this measurement is metrics, they are more increasingly seen as important across the industry and can be used for many aspects of an impact investment venture, for example, risk identification during due diligence through ESG screening and allow the tracking and improvement of investments to meet social goals  (Best and Harji, 2013).

Not only are metrics an important factor, outcomes themselves are the end goal and there are a number of factors that both control their eventuality and how they are assessed. Reeder et al. (2015) argues that three key groups have control over the outcome domain the impact investor, the technical experts developing the system, and wider stakeholders, arguably those to feel the impact, with the last group also likely having the lowest control as those in more control have a higher influence over metric choices and investment decisions. The paper also highlights that the attitudes to risk may differ greatly between stakeholders with those that are impacted have a much more personal risk that in some cases, could be detrimental to their fundamental way of life. As such, it is arguably important to both, understand an investors approach to risk as well as what aspects are a priority when investing.

These are some of the aspects that need further understanding if to effectively apply different approaches proposed in the literature such as, Tobias’ SRI approach to portfolio theory within the field of impact investing, specifically when it comes to understanding the quantification of how impact is applied at the investment and portfolio choice stage.

Specific approaches to quantifying impact

One key approach highlighted by (Jackson, 2013) is the theory of change, he argues that it should be key to impact analysis and theory of change could effectively be used to build up and tackle measuring impact upon social and environmental aspects of investing, by refining and developing over time, not as a single all-encompassing methodology but applied in combination with other methodologies. It is argued that qualitative methods such as most significant change stories or attribution analysis for examining cause and effect relationships. While this approach allows the flexibility to address such a wide variety of asset classes and impact areas it does not help to address some of the issues surround optimisation of impact, either through the suggesting approaches above or through addressing some of the issues on impact definition.

While it could be argued that other current analytical approaches like monetization methods allow for easier cross industry comparison, this does come with limitations, these should be combatted with the inclusion of qualitative methods to increase accuracy and transparency. In very much the same way that GDP is not the only relevant metric for national development and growth, neither can these methods be for measuring precise impact (Reeder et al, 2015). It could also be argued that the majority of economic indicators focus on a singular outcome, however, a large number of social innovations will address a number of different outcomes (Antadze et al, 2012).

According to Reeder et al, (2015) they are generally two main measurement approaches, these being a systematic or a case by case approach. The systematic approach has also been built upon in the literature by Saltuk and Tobias, with their entire portfolio overview. While most impact investors also state they don’t utilise post investment tracking or measurement beyond the investment phase, this was not as highly prioritised because of the associated costs. (Purpose Capital, Best and Harji, 2013).

Specific challenges

There is also a great deal of challenges to be met when working to create metrics, tools and frameworks for the impact investing industry, particularly due to the high diversity in portfolios and investments. While the literature also finds, due to this fact that a standardisation could lead to reduced accuracy in measurement, while a number of investors  also feel that some aspects of measuring impact can be costly (Best and Harji, 2013). One way to combat this could be by convening around sector-specific metrics through which investors could improve the efficiency and applicability of measurement for their investments. (Purpose Capital, Best and Harji, 2013).

Another difficulty highlighted by Reeder et al. (2015) is the difficulties in attributing effects and suggests randomised control trials are important in assessing the rigour of assessment. Another challenge mentioned by Reeder, like Best and Harji, is that of the financial limitations of impact investors themselves in assessing the outcomes of their interventions.

There are also a number of technical innovation challenges to overcome, the impact and outcomes of more social innovations cannot, at least initially, be judged by growth in market share or profitability. The difficulties inherent in attempting to capture and calculate the full impact often hinders high-performing not-for-profits, social entrepreneurs, social enterprises from accessing capital from investors and donor’s due to a short-term approach of reporting in traditional investment (Idib).

Knowledge gaps

Therefore, from an academic view point there are a number of areas that need further investigation and academic research can clearly add value in increasing the understanding and building knowledge of impact investing. Specifically in the areas of understanding risk, interpreting investor behaviour and particularly helping to improve the assessment of the value produced from impact investments (Impact assets, 2016).

There are many specific knowledge gaps still to be overcome, in areas including; What drives the decisions that investors make and how this can be better understood to improve impact, understanding the full effect a firm’s decision-making processes have on impact investment and how to better incorporate sustainability into existing investment literature. While there are also more specific gaps relating to measuring impacts, specifically the most effective approaches to impact measurement, improving reporting on these aspects of impact investment, how the theory of change could potentially improve current methodologies and whether suggested approaches from the literature are effective in practice.

As such this thesis aims to fill some of these gaps surrounding the understanding investor behaviour, for example, what drives these investors, as well as, trying to define both what is impact investing, what constitutes a successful impact investment and how investors value various attributes of an impact investment.

Antadze, N. and Westley, F. R. (2012) ‘Impact Metrics for Social Innovation: Barriers or Bridges to Radical Change?’, Journal of Social Entrepreneurship.  Routledge , 3(2), pp. 133–150. doi: 10.1080/19420676.2012.726005.

Best, H. and Harji, K. (2013) Guidebook for impact investors: Impact Measurement.

Fehr-Duda, H. et al. (2010) ‘Rationality on the rise: Why relative risk aversion increases with stake size’, Journal of Risk and Uncertainty, 40(2), pp. 147–180. doi: 10.1007/s11166-010-9090-0.

Glac, K. (2008) ‘Understanding Socially Responsible Investing: The Effect of Decision Frames and Trade-off Options’. doi: 10.1007/s10551-008-9800-6.

Gurevich, G., Kliger, D. and Levy, O. (2009) ‘Decision-making under uncertainty – A field study of cumulative prospect theory’, Journal of Banking and Finance, 33, pp. 1221–1229. doi: 10.1016/j.jbankfin.2008.12.017.

Hofmann, E. and Kirchler, E. (2008) ‘A Comparison of Models Describing the Impact of Moral Decision Making on Investment Decisions’, pp. 171–187. doi: 10.1007/s10551-007-9570-6.


Impact assets (2016) ‘An ImpactAssets issue brief exploring critical concepts in impact investing’. Available at: (Accessed: 22 July 2017).

Jackson, E. T. (2013) ‘Interrogating the theory of change : evaluating impact investing where it matters most’, Journal of Sustainable Finance & Investment, 795(February). doi: 10.1080/20430795.2013.776257.

Kahneman, D. and Tversky, A. (1979) ‘Prospect Theory: An Analysis of Decision under Risk’, Econometrica, 47(2), pp. 263–292. Available at: (Accessed: 22 June 2017).

Markowitz, H. (1952) ‘Portfolio Selection’, The Journal of Finance, 7(1), pp. 77–91. Available at: (Accessed: 28 June 2017).

Papadakis, V. M. (1998) ‘Strategic Investment Decision Processes and Organizational Performance: An Empirical Examination’, Britisch Journal of Management, 9, pp. 115–132.

Peylo, B. T. and Tobias, B. (2012) ‘A Synthesis of Modern Portfolio Theory and Sustainable Investment’. Available at: (Accessed: 20 July 2017).

Pomares, G. (2009) ‘Solutions for Impact Investors: From Strategy to Implementation’. Available at: (Accessed: 21 July 2017).

Purpose Capital, Best, H. and Harji, K. (2013) ‘Social Impact Measurement Use Among Canadian Impact Investors’, (February). Available at:

Reeder, N. et al. (2015) ‘Measuring impact in impact investing: an analysis of the predominant strength that is also its greatest weakness’, Journal of Sustainable Finance & Investment. Taylor & Francis, 5(3), pp. 136–154. doi: 10.1080/20430795.2015.1063977.

Saltuk, Y. (2012) A Portfolio Approach to Impact Investment.

Tobias, B., Benjamin, P. and Peylo, T. (2014) ‘Rational socially responsible investment’. doi: 10.1108/CG-08-2014-0089.

Virlics, A. (2013) ‘ScienceDirect Investment Decision Making and Risk’, Procedia Economics and Finance, 6, pp. 169–177. doi: 10.1016/S2212-5671(13)00129-9.

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