Where does patient capital come from? Other than altruism/social-mindedness and, as I alluded to in an earlier post, a penchant to build for the long-term, what motivates patient capital?
Research in behavioral economics suggests there may be many more dynamics at play here. Do these dynamics bode well for the future of patient capital? It seems they do.
Let’s start with a thought experiment.
Imagine you are going through a stack of old mail and papers. Much to your surprise, you find an unopened college graduation card with a $100 bill inside. You have the option to either 1) invest that $100 for the next six months or 2) spend it immediately, perhaps to pay down some credit card debt or buy a few books on social enterprise you’ve been wanting to read.
How much would you have to get back on your six-month, $100 investment to choose investing over consuming? Seriously, write down a number.
Now imagine, however improbable it may be, that the card was from a rich aunt and the amount inside was $1,000. Again, you have the option to spend or invest. How much does that potential investment need to be worth after six months in order to forego an awesome shopping spree?
Instead of six months, now pretend that the timeframe is four years. Now how much would you need to get back on either the $100 or $1000 investments to delay spending? Again, write down what seems reasonable.
If you are like most people, you probably said that the $100 would need to turn into something like $125 in six months to prevent you from spending it (50% annual return). On the other hand, you would probably be satisfied with something like $1,100, a gain of $100 (20% annual return), in scenario two.
Where the time horizon is four years versus six months, you’d maybe require $200 in exchange for your $100 investment (19% annual return) and $1750 (15% annual return) where the initial investment was $1000.
So what? Well, you may have noticed that the shorter the time horizon and the smaller the investment, the greater your ROI requirements (in economist-speak, your discount rate is higher). When the numbers are larger and time horizons longer, you are probably satisfied with lower rates of return.
Source: Mike Shoemaker
It’s not 100% clear why this is so. My reading on traditional economic theory suggests that longer time horizons and larger amounts should carry greater risk and therefore require higher returns. But the experimental research to the contrary seems fairly robust. It may be partly that our mental accounting puts smaller cash amounts into a consumption account (“it’s only $100 after all…”), whereas larger windfalls go into a mental savings account and are thus more likely to be invested, even at lower returns.
It could also have something to do with an emphasis on absolute versus relative values. A return of $100 on an investment of $1000 sounds better than getting $25 back on a $100 investment, even though the latter has a much higher rate of return.
As far as time horizons, we have lots of adages that confirm our tendency to value things more highly the closer they are in time or proximity. “So close you can taste it.” Or “a bird in hand is worth two in the bush.” In fact, what we may be experiencing here is some variation on the “endowment effect” (e.g., you probably think your home is worth more than the value anyone else out there would place on it).
Regardless, the behavioral economics research makes patient capital look pretty promising. While sinking our money into a long-term venture that promises lower returns may seem irrational, intuitively it is likely to “make sense” to a lot of us.
The bad news may be that, in general, our tendency is to be myopic versus patient. We like immediate gratification and struggle to make and keep long-term commitments. And so there is more money allocated toward gambles out there than there are monies earmarked toward patient capital. A quick look at the success of both Vegas and the lottery, as well as the amount of speculation in the stock markets, confirms this. (Interestingly, Kiva’s success may also be a good example of harnessing people’s tendency to invest where amounts are smaller AND returns are short-term.)
So what’s the lesson here? There are two, I think:
- If behavioral economists are right, patient capital has a natural home on the Gamble-Invest-Donate continuum (see above) before even taking into consideration people’s altruistic tendencies. If fits part of human nature. That’s a great thing.
- Secondly, if you’re in the philanthropy business, there might be a lesson here for matching the magnitude of the donation you’re requesting to the time horizon of the “return.” Again, Kiva has been hugely successful and just happens to be asking for small amounts of money that generally get paid back within 6-12 months. Are you asking for $50 donations for capital campaigns or long-term initiatives with less tangible payoff? How’s that going for you?
NOTE: These ideas are largely adapted from research presented in Richard Thaler’s, “The Winner’s Curse.” If you don’t mind academic reading, check it out.
Contributor Profile: Mike Shoemaker
Mike is a graduate of St. Olaf College in Minnesota and a former Fulbright Scholar at the Universidad de los Andes in Bogota, Colombia. Mike currently manages strategic alliances for a global consulting firm, is a volunteer and advisor to The Ayllu Initiative, and blogs at Human Ventures.
Twitter: @soccapital
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