Finance professionals are increasingly committed to addressing complex societal challenges, not least because of an increasing desire of citizens (the ultimate owners of all financial assets) to invest sustainably. Yet many investors are currently ill-equipped to move beyond incrementalism and deploy capital in a manner that catalyses systems transformation, including multilateral institutions, public sector actors, and impact investors.
The root cause, we believe, is a set of paradigms, structures, and practices that guide decision-making in the financial industry and limit its ability to finance transformative change in socio-technical systems.
Paradigms are the shared ideas in the minds of the members of a community, the deepest and commonly accepted beliefs about how the world works. They are the foundations of a system, defining its goals, information flows, feedback loops, material stocks and flows, and indeed everything else. Paradigms thus exert the greatest leverage on a system’s behaviour and are thus a potent place for intervention.
Notions of Value
A central paradigm of today’s finance industry is that "valuable" is only what can be measured in monetary terms and captured through transactions. This means that capital markets cannot relate to sources of value outside this narrow definition.
As a result, traditional investors consider public goods (such as political stability, social equality, and ecological sustainability) as exogenous factors, i.e. aspects that sit outside their sphere of influence and thus outside their sphere of responsibility. They feel little obligation to foster intrinsic societal values that exist beyond the “money in/money out” logic.
This is a moral issue for some. But it can become a financial problem for capital markets at large if the deterioration of public goods diminishes monetary wealth or makes our economies more fragile. For instance, the Economist Intelligence Unit estimates that, in a worst-case scenario and with a view towards the year 2100, as much as $43 trillion (or 30%) of value stored in the global stock of manageable assets could be at risk from the effects of climate change. So investors would act in their own self-interest if they expanded their notions of value.
The Nature of the World
The narrow conception of value that currently dominates financial practice derives in part from the way many investors view the systemic nature of the world. They assume that economies are complicated systems, in which the relationships between cause and effect are clear and in which the nodes, interrelationships, and feedback loops can be identified, through careful analysis, by those who possess the right kind of expertise.
Yet complexity science teaches us that human civilisation (and economies and markets in particular) behaves instead as a complex adaptive system.
Why does this matter?
Because how investors view the nature of the world determines what mindsets, frameworks, and tools they deploy for solving a problem. A worldview steeped in complicatedness leads to approaches that are reductionist, atomistic, and mechanistic. What matters then is the function, property, and promise of individual units. This is why finance practitioners are so fixated on single projects and securities. It also explains why investors rely on probabilistic models to forecast the performance of financial assets.
Traditional finance orthodoxy assumes that society at large, and economies in particular, are complicated systems. Yet science tells us that they behave as complex adaptive systems. This distinction matters because operating in complexity requires different mindsets, approaches, and tools than those prevalent in the financial sector today.
Complexity, by contrast, is the domain of emergence, in which we can understand why things happen only in retrospect. In other words, in complex contexts, the future cannot be predicted, but it will instead reveal itself over time, which is why probabilistic and deterministic models are of limited use.
So there is a mismatch between the nature of the models that investors use and the true nature of the context in which these models are applied. If investors want to address systemic problems, they must adapt their mindsets and tools to the realities and needs of complexity.
The Agency of Money
Another set of beliefs, though one that is rarely stated, revolves around the agency of money itself. What role, exactly, does financial capital play in driving a system’s behaviour?
Many investors see money as a passive entity that flows through a “landscape of opportunity” to the most attractive assets. In this worldview, the force that governs such capital flows emerges from the relative risk/return ratios of different assets within the investable universe.
Investors who subscribe to this view assign policymakers the role of landscapers and themselves the role of system optimisers whose job is to exploit profit opportunities within the boundaries of the investable universe. These investors then adopt a reactive mode of operation, feeling little responsibility for (and influence over) the general course of the world.
An alternative view posits that money is an active entity in determining what happens in a system and that the real landscapers are, in fact, investors themselves.
Are these just philosophical musings? Not at all. Money is a powerful lever in driving systemic change, and it is investors who wield that power. Climate change is already threatening long-term prosperity. Operating in a reactive modus operandi and waiting for lawmakers to change the boundary conditions for investment will almost certainly be detrimental to the goal of long-term wealth preservation.
Financial Mathematics and the Conception of Value, Risk, and Return
In finance, decisions are often based on mathematical models. It is tempting to view these models as truisms. But doing so would neglect that they are, in fact, expressions of a range of beliefs about what is valuable, how that value is best managed, and how it materialises in markets.
The Discounted Cash Flow (DCF) method is a case in point. It makes a normative statement about what is valuable and how "value" ought to be calculated. Indeed, the norms implied in the DCF method condition a whole industry to prioritise short-term profits over long-term value, disregard the externalities—both positive and negative—that their investments might generate, neglect systemic risks, and ignore the fundamental uncertainty of complex adaptive systems.
Another set of mathematical models come from Modern Portfolio Theory (MPT), a dominant paradigm for managing risk at the level of portfolios. MPT postulates that systemic market risk and return are exogenous to investing (i.e., outside of the sphere of influence of investors), and that risk management is best pursued through diversification at the portfolio level. MPT is the dominant force behind the finance industry’s focus on relative returns and short-term performance and behind the low sense of agency of investors over mitigating systemic risks.
To be clear, there is nothing wrong with a decision-making approach steeped in mathematics. Yet investors must acknowledge that their models reflect not so much absolute truths but a set of norms and values, and that the finance industry’s objective functions fail to set us on a path to long-term sustainability and wealth preservation.
Practices and Structures
To ensure conformity with these paradigms, the financial industry embraces and self-enforces a set of idiosyncratic practices and structures that impede the adoption of a systemic approach to investing.
The majority of investors analyse and trade single assets—they focus on one stock, one bond, or one project loan at a time. In following the single-asset approach, investors disregard what the sustainable development sector has understood for a long time—that single interventions rarely lead to systemic change. They miss out on combinatorial effects that arise when investments are aligned and coordinated to create strategic synergies. So assessing and selecting one asset at a time is not an effective strategy for generating outcomes at the system level.
Risk-Based Portfolio Composition
Risk-based portfolio composition, as is suggested by MPT through the bundling of weakly or negatively correlating assets, has limited potential to unleash transformative change because it underplays aspects of value. Investors following this approach tend to disregard any value that emerges at the aggregate level of the portfolio through strategic synergies (i.e. through positive correlation).
Selecting assets not only based on their individual merits and for the purpose of risk diversification but also for their collective interplay can make a portfolio more valuable and impactful.
Categorisation and Other Unhelpful Practices
The finance industry is categorical in the extreme. Investors use a long list of classifications to not only segment the investable universe (e.g. into asset classes, investment styles, time horizons, market maturity profiles, sectors, bands of creditworthiness, currency baskets, etc.) but also to organise teams, design processes, manage risks, train employees, capture knowledge, and even shape corporate culture. Such a bias for categorisation creates a degree of compartmentalisation within financial institutions that sits at odds with the notion of complexity.
There are other practices that limit the financial industry’s ability to unlock the positive returns that come from a systemic, integrated approach. These include the static approach to defining asset allocations, the crude heuristics that underly normative investment horizons for different asset classes, the homogenous recruitment and training methods of banks and financial intermediaries, and the myopic incentive systems with which financial institutions reward their employees.
In combination, these paradigms, structures, and practices make the finance industry ill-equipped to make more than merely incremental contributions to resolving complex societal problems. In fact, they achieve the opposite of what the world now requires. Instead of enabling finance to adapt itself to the changing needs of society, they confer a status quo dependency—capital markets today depend on systemic stability, as the 2008-2009 financial crisis and the COVID-19 pandemic have highlighted. This status quo dependency sits fundamentally at odds with the need to change almost all aspects of how our societies and economies operate.