Managing Risk in Social Impact Investing

Mar 20, 2018 11:17:07 AM / by Koen The, CEO | 3 minute read

At Lendahand, people can invest in our local partners (banks and non-banking financial institutions) or directly to entrepreneurs through crowdfunding. These investments have interest rates of approximately 2.5 to 8 percent annually. As you can see, this is quite a difference. The higher the interest, the higher the price that needs to be paid. But the price of what, exactly?

A Free Lunch?

Ask professional investors about the most important measurement to estimate attractiveness of a financial product and they will probably say: risk, that is volatility.

You would expect they would give us an answer as “expected returns”, instead of risk, but the well-accepted theory states that returns are a function of risk. William Sharpe won the Nobel prize for this observation (maybe CAPM rings a bell). It is the Sharpe ratio, a weighted efficiency measure that is commonly used by institutional investors.

Next to Sharpe, more Nobel prize winners formalized the relationship between risk and returns, like Markowitz. Basically, long-term risk can only be reduced if investments are diversified, without turning in returns. You can compare this to the only free lunch in the financial world. Even adding a high-risk investment to your wallet can lead to a diminished risk on your wallet, depending upon the correlation of that one investment with the others. The more diverse the investments, the better.

Are you still with me?

 

Risk Reduction

Apart from diversification, you could see interest/returns as the price that needs to be paid for running a certain risk. This could be the risk derived from keeping money at ABN AMRO, and that if the bank collapses, the government is not capable of successfully cover the Deposit Guarantee Schemes. A very small risk indeed, thus a relatively low return as well.

Further on in the risk-return spectrum, you can find (for instance through Lendahand) investing in solar companies in Africa. Some of these projects have return rates of 8 per cent per annum. However, it is a young industry with many undefined variables that could interfere. Therefore, a higher return-rate goes hand-in-hand with a higher risk-profile.

 

Three Recommendations for Social Impact Investors & Crowdfunders: Diversify, Diversify, Diversify

You can save money on your bank account at one of the big Dutch banks, invest in crowdfunding, and invest in a solar company in Africa, or anything in between the risk-return spectrum. Have a nice cup of tea and relax. For instance, imagine investing in bonds from a foreign bank that is supervised by its country’s national central bank, has been active for several years, and has quite an expansive loan portfolio. An investment like this implicates a lower risk which justifies a lower interest rate. Naturally, with a foreign bank, the chance you lose all of your investment will always be present.

Following theory, investors –as long as risks are fairly appraised– should take in a neutral position towards investing in low risk-return rated parties as well as high risk-return rated parties. Moreover, as described above, investable assets should be divided into different profiles and different offers. It is always highly recommendable to keep a responsible amount of your money as savings and the other part in your built up investment portfolio.

 

Conclusion

Social impact investing is more about just the returns. Of course you want to earn a return on your investments, or else it wouldn't be called investing. However, this may not be the best investment option for you if financial returns alone are your highest priority. 

You should not engage in social impact investing through crowdfunding solely for the projects with the highest interest rates. Again, diversification is the only ‘free lunch’ and if interest rates represent risk rates correctly, normally you should be willing to invest in projects that offer lower interest rates as well.

However, there are always exceptions to the rule: a handful of people can beat the market systematically by cherry picking the right investments. But be careful, because speaking with John Keynes words:

“The market can stay irrational longer than you can stay solvent."

Topics: crowdfunding, investing, impact investing

Koen The, CEO

Written by Koen The, CEO

I would like to use my skills from various investment banks in London to give children in poor countries a better future. By investing sustainably, you improve the future of many but also of yourself. Previously with Goldman Sachs and Barclays.

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