THROUGH THE BEHAVIORAL FINANCE LENS Impact Investing: Your Priorities and Your Portfolio

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1 THROUGH THE BEHAVIORAL FINANCE LENS Impact Investing: Your Priorities and Your Portfolio Merrill Lynch Behavioral Finance SUMMER 2018 Andrew Porter, Director of Behavioral Finance SUMMARY In this paper, we will examine impact investing through the behavioral lens to help empower your decision making. Behavioral finance combines the disciplines of psychology and economics to understand how real people make financial decisions. It can be a powerful tool for investors and their advisors to pursue financial goals with confidence. We hope that after reading this paper, you feel empowered to consider what makes you unique as an individual, as an investor, and as a client. More and more investors are expressing interest in impact investing, yet only a relatively small number have taken steps to actually incorporate impact considerations in their portfolios. 1 This paper analyzes the pronounced gap between interest and implementation what one might call the impact behavior gap and explores common behavioral or psychological obstacles to incorporating impact considerations into an investment strategy. It also offers steps to help investors and their financial advisors engage in a meaningful dialogue, in order to close that gap. Key points This paper addresses three key points investors should consider when thinking about using impact investing within an investment portfolio: The availability of impact-related information and how we approach it Perceived trade-offs and the framing of conversations Practical constraints and pragmatic choices Getting Started: What are my investment priorities? As a first step to thinking about impact investing, it s important to evaluate your priorities as an investor. To begin this process, consider which of the following statements reflects your approach: As an investor, it is important that I Seek to maximize the performance of my portfolio. Consider how my investments could produce returns. Invest in companies devoted to achieving positive social or environmental outcomes. ¹See How we approach Impact Investing at Merrill Lynch on page 3 for an overview of impact investing. Impact investing and/or Environmental Social Governance (ESG) investing has certain risks based on the fact that ESG criteria excludes securities of certain issuers for nonfinancial reasons and therefore, investors may forgo some market opportunities and the universe of investments available may be smaller. Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S) and other subsidiaries of Bank of America Corporation (BofA Corp.) Investment products: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value MLPF&S is a registered broker-dealer, Member SIPC and a wholly owned subsidiary of BofA Corp.

2 Did you select just one of the options? If so, you are not alone. It s not uncommon for investors to regard these choices as incompatible. For instance, you may feel (at the intuitive or gut level) that investing based on an interest in social or environmental impact will require a compromise on financial returns. Or, you may view impact creation through a lens of philanthropy, with a clear line between it and your investment portfolio. But whether choices around impact actually require real trade-offs depends on a myriad of factors that aren t always understood by investors or financial advisors. In order to achieve clarity on tradeoffs and choices, it is useful to consider what information is included in an investment decision, how decisions are made, as well as how additional factors such as competing priorities and constraints can affect the deliberation process. In short, it is useful to think through how we make decisions, in order to achieve clarity about our options in an effort to gain confidence about which investment choices may be right for each of us. Exhibit 1 Interest in impact investments is higher than ownership PERCENTAGE BY YEAR WHO OWN OR ARE INTERESTED IN IMPACT INVESTMENTS 11% Own 12% 27% 28% Interested Exhibit 2 Age is inversely correlated with both ownership and interest in impact investments. PERCENTAGE BY AGE WHO OWN OR ARE INTERESTED IN IMPACT INVESTMENTS (2018) Information: What are my options and how do I consider them? Routine is an important part of any investor s financial life. Yet, when investment decisions become routine which can certainly happen over years or decades of investing experience it becomes easy to write-off new or evolving ways to invest. Furthermore, the ways that we commonly identify, select and process information are typically not neutral and may be impacted by a host of biases, including, but not limited to: Awareness & Access: Am I aware that new information exists? Do I rely heavily on a narrow range of sources and types of information? Do I feel like I have access to adequate resources to learn about a new concept? Assumptions: Am I already familiar with the information? Have I already developed an opinion about it? Avoidance: Do I feel overwhelmed by the breadth of new information? Am I uncomfortable revising previously-held beliefs or revisiting investment decisions? In short, while it is natural and time-efficient to adopt routines and even use shortcuts in information-processing and decision making, it is critical for investors and their advisors to do so in a way that enables discussions about new concepts or information. This is especially pertinent to impact investing, which has evolved significantly over the past decade, shedding many misconceptions about it along the way. 2 In this domain especially, investors and advisors can benefit by approaching new information with an open mind. Exhibit 3 Discussions with advisors about impact investing are infrequent. 40% 37% 39% PERCENTAGES OF INVESTORS WHO HAVE IMPACT INVESTING WITH THEIR ADVISOR 20% 26% 17% Own Among All HNW Investors Among HNW Investors who own or are Interested in Impact Investing Millennials Gen X 8% Boomer 3% Silent Interested 89% HAVE NOT 11% HAVE 74% HAVE NOT 26% HAVE 2 Interst in impact investing is growing: the total U.S.-domiciled assets under management using impact strategies grew from $6.57 trillion at the start of 2014 to $8.72 trillion at the start of 2016, an increase of 33 percent. Source: Deconstructing Risks in Impact Portfolios. Merrill Lynch Impact Investing: Your Priorities and Your Portfolio 2

3 That said, just because new information exists does not mean it will be incorporated into investment decisions. So how can investors and advisors ensure that investment choices are more broadly informed and empowered? The following questions provide a good place to begin. What research, information, and resources exist to educate myself on impact investment options? What do I own, currently? How did I arrive at these allocations? What has changed since I arrived at them? How do investors like me typically think about the impact of their investments? Where have they found success? How we approach Impact Investing at Merrill Lynch Merrill Lynch defines impact investing as investments made into companies, organizations and funds with the intention to generate measurable social and environmental impact alongside a potential financial return. The Impact Investing Framework, featured below, outlines Merrill Lynch s main approaches to impact investing. Trade-offs and framing: Is impact a goal, a means to a goal, or a mixture of both? In recent years, countless reports and organizations have been created related to impact investing. As a result, if access to information is considered the main driver of implementation, one would expect to see more investors using impact investing today. Yet preconceptions about investment choices and options, including the belief that impact investing can potentially lower performance, can stall impact conversations before they start. What can help break this impasse is to consider how investment choices are presented or, adopting the language of behavioral finance, how these choices are framed. Exhibit 4 Impact Investment Performance vs. benchmark 28 year comparison ( ) of the cumulative return % for the MSCI KLD 400, an index of companies that meet best-in-class environmental, social and governance (ESG) criteria vs. the S&P S&P 500 TOTAL RETURN KLD 400 TOTAL RETURN Source: MSCI, S&P Past performance does not ensure future performance outcomes. Note: Indexed to ,000 1,500 1,000 This chart is a hypothetical example meant for illustrative purposes only. It does not reflect an actual investment, nor does it account for the effects of taxes, any investment expenses or withdrawals. It is not intended to serve as investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. Returns are not guaranteed and results will vary. Investment returns cannot be predicted and will fluctuate. Investor results may be more or less. It is not possible to invest in an index. When it comes to designing an investment portfolio, investors and advisors typically seek to do more than achieve financial returns. More specifically, they seek to achieve returns in a certain way, as specified by investor goals and priorities, risk profile, and other considerations. It is here that impact can play a role in identifying and selecting investments. Yet it is also here that some investors rule out impact factors, by framing impact as a goal rather than as a means to a goal The Merrill Lynch Impact Investing Framework SOCIALLY RESPONSIBLE SUSTAINABLE THEMATIC IMPACT FIRST Screen out entities based on faith-based or other personal preferences Proactively choose entities that excel at a range of environmental, social and governance (ESG) factors Investment opportunities that focus on environmental or social themes Investments dedicated to addressing specific social or environmental concerns using market- based investment strategies Avoid investments associated with: Seek investments in companies that: Target areas of growth in: Pursue investments that aim to: Environmental harm Promote and achieve sustainability Green initiatives, such as climate change or water security Improve early childhood education Tobacco, firearms, alcohol Encourage and measure corporate social responsibility Gender equality and diversity Reduce prisoner recidivism Practices that are in conflict with religious beliefs Are leaders in fair trade and factory worker safety Healthcare and the global trend toward obesity Address homelessness Impact Investing: Your Priorities and Your Portfolio 3

4 It is possible and not uncommon to invest with the goal of creating social and environmental impact. 3 But trying to do good while doing well, as it were, can make impact feel like a constraining factor in the pursuit of financial return to some investors. This is why it is critical to reflect on how choices are framed, so as to limit or avoid the feeling that there is cost or conflict where little, if any, may actually exist. A good starting point is to ask: Would considering how my investments make money enable me to improve my investment decisions? One approach to consider is framing impact as a means for achieving potential financial and personal goals. This can help avoid muddling mental accounts (see below), thus maintaining focus on one s core objectives for investing. Investors and their advisors can assess the instrumental value of impact by answering the following questions Can Impact Investing help maximize the performance of my portfolio? 2. Can Impact Investing help me consider how my investments produce returns? 3. Can Impact Investing help me invest in companies devoted to achieving positive social or environmental outcomes? What is mental accounting? Generally, economic theory assumes that people make financial decisions using a comprehensive account, wherein money is valued equally across all transactions. But research suggests that we actually create distinct accounts for our money, mentally labeling it according to origin (source) and purpose (uses). 5 Furthermore, we assess these accounts, evaluate transactions, and measure outcomes in ways that have an impact on our decision making. Mental accounting is not neutral: the ways we frame financial choices affect the attractiveness of options and, therefore, shape our decisions. This poses both advantages and disadvantages for personal money management; mental accounting saves us time and effort and, in many cases, helps us exercise selfcontrol. But if we re not careful, it can also lead to mistakes that range from insignificant to critical. 6 Practical constraints and pragmatic choice: How do I get started? It is not uncommon for investors considering impact whether as a distinct goal or an instrument for improving performance to face practical constraints. In some cases, attempts to introduce impact factors can be complicated by more immediate priorities or prior commitments. 7 Therefore, working with a financial advisor to help ensure that impact choices add value to one s investment strategy is paramount. The following points of discussion addressing priorities, process, and performance can help do just that. Concluding thoughts Impact need not feel like a trade-off, but getting clear on the possible implications of investment choices requires reflection, communication, and perspective. Whatever the motivation for introducing impact factors into a portfolio, deliberating on the availability of information, reality of trade-offs, and practicality of constraints can help investors gain confidence in their investment decisions. Behavioral finance may not tell investors or financial advisors what to choose, but it can help them think more clearly about the impact of their choices. 1. Which of my goals may offer flexibility in regards to how I pursue them? Do any of my current account types afford greater flexibility with regard to transaction costs, taxation, and liquidity needs? 2. Would incremental or scheduled/delayed changes lessen the (perceived) challenge of integrating impact investing into my portfolio? Is there a simple next step, such as allocating a certain portion of my portfolio to impact investments, I could implement first? 3. How (and when) will I review our decisions and results? 3 Indeed some investors may dedicate a portion of their wealth to social or environmental causes, through charitable giving, philanthropic foundations, direct investments in impactoriented businesses, and support for nongovernmental organizations. 4 For those investors who define social and environmental impact as a goal-in-itself, these steps can add additional value to the investing process, by generating impact utility in addition to their charitable and philanthropic endeavors. 5 Additionally, level of wealth affects how we make financial decisions, in ways that traditional models cannot accommodate. That many people will drive across town to save $5 on a $15 calculator, but not $5 on a $500 smartphone illustrates that the value of money is dependent upon context, choices, and other considerations. Source: Mental Accounting Matters. Thaler, Richard. Journal of Behavioral Decision Making For example, dividing one s investment portfolio into safe and speculative investments can obscure or misrepresent the riskiness of one s overall investment portfolio. 7 For example, an investor seeking to make their portfolio s energy sector allocations greener may find the tax consequences of liquidating current positions to be undesirable, if not prohibitive. Impact Investing: Your Priorities and Your Portfolio 4

5 Andrew Porter is Director of Behavioral Finance at Merrill Lynch Wealth Management. A Robert Bosch Foundation Transatlantic Leadership fellow, Andrew earned an M.A. in philosophy from the Graduate Center, City University of New York, and holds a B.A. in philosophy from the College of William & Mary in Virginia. Merrill Lynch s Wealth Management Institute offers clients some of the world s best intellectual capital on topics that complement our traditional investment management and portfolio construction advice. The Wealth Management Institute helps clients and advisors create holistic and customized solutions by combining Merrill Lynch s expertise in managing wealth for individuals, families and institutions with our internal thought leadership and professional network of industry luminaries and leading academics. All Wealth Management Institute thought leadership is driven and vetted by the Investment Management & Guidance leadership team. Investing involves risk. There is always the potential of losing money when you invest in securities. This article is provided for information and educational purposes only. The opinions and views expressed do not necessarily reflect the opinions and views of Bank of America or any of its affiliates. Any assumptions, opinions and estimates are as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account a client s particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument or strategy. Before acting on any recommendation, clients should consider whether it is suitable for their particular circumstances and, if necessary, seek professional advice. Chief Investment Office Due Diligence provides investment solutions, portfolio construction advice and wealth management guidance. Global Wealth & Investment Management (GWIM) is a division of Bank of America Corporation. Merrill Lynch Wealth Management, Merrill Edge, U.S. Trust, and Bank of America Merrill Lynch are affiliated sub-divisions within GWIM. The Chief Investment Office, which provides investment strategies, due diligence, portfolio construction guidance and wealth management solutions for GWIM clients, is part of the Investment Solutions Group (ISG) of GWIM. This information should not be construed as investment advice. It is presented for information purposes only and is not intended to be either a specific offer by any Merrill Lynch entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available through the Merrill Lynch family of companies. NNeither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions Bank of America Corporation. All rights reserved. ARS5NHNW