Financial disclosures can make advice worse: Yale study

July 14, 2011

Washington watchers are sure to see a lot of one particular word in the months to come: disclosure.

The Securities and Exchange Commission is preparing a fiduciary standard for brokers that is expected to require them to disclose their financial conflicts. The Consumer Financial Protection Bureau plans to launch next week with a plan for new mortgage term disclosure forms. And Elizabeth Warren, the president’s adviser who set up that agency, has given speech after speech in which she discusses the virtues of requiring clear disclosures as a mode of financial regulation.

“Regulations should be about making sure that customers have the information they need to make the decisions that are right for them,” she has said, in some form, over and over.

There’s just one thing wrong with all of those disclosures: They don’t always work. Sometimes, they actually encourage consumers to make bad decisions, according to a new survey of academic research.

“We aren’t saying that disclosure or transparency is a bad thing,” Daylian Cain, an assistant professor of organizational behavior at the Yale School of Management, and one of the study’s authors, says. “But our research has found some instances where it has a perverse effect and can make consumers worse off. It just doesn’t work as well as we think it does.”

In addition to the obvious problems with disclosures done poorly — those overly long, incomprehensible, 60-page boilerplates that come attached to every new account and that Warren wants to simplify — there are disclosures done well enough that still have the wrong effect, says Cain. He is skeptical that commissioned investment salespeople will be able to act in the best interests of their clients if they simply are required to disclose that they are paid to sell certain products. (The leading securities industry trade group asked the SEC for just such a rule in a letter released today.)

“We found that conflicted advisers who disclose their conflict gave worse, more selfishly biased advice than those who didn’t disclose. They felt more comfortable giving misleading advice,” he says.

Cain and his co-authors — George Loewenstein of Carnegie Mellon University and Sunita Sah of Duke University — did a literature review of studies (several of which were their own) about the effects of disclosure. Their paper, “The Limits of Transparency: Pitfalls and Potential of Disclosing Conflicts of Interest,” was published in the May issue of the American Economic Review. It asserts that consumers presented with their adviser’s conflict of interest often become reluctant to appear unwilling to help the adviser.

In other words, if clients are sitting across the table from an adviser they like, they may want to help him get his commissions by agreeing to the products he is recommending. And the adviser may feel that, having made his disclosure, he’s free to recommend the most self-serving products around. “Rather than get off the gravy train, these conflicted advisers would rather simply just disclose that they are on it,” says Cain.

Individual investors don’t even know how to interpret these conflict-of-interest disclosures and they are reluctant to put in the time and effort to get second opinions, says Cain. Even if they do get second opinions, they aren’t sure what to do with them.

The takeaway for investors? There are a few:

1. Some disclosures are particularly useful
Think, for example, of those super-simple mortgage forms that Elizabeth Warren has in mind. Or the numbers in annual reports. Or the fee tables in mutual fund prospectuses. That’s solid information, offered at a time when you can easily comparison shop.

2. Disclosure isn’t a substitute for regulation
“Care must be taken… to ensure that disclosure does not replace more effective measures, such as working harder to eliminate conflicts of interest in the first place,” the paper concludes.

3. Everyone has conflicts
Advisers who are paid by the hour instead of through commissions may recommend less expensive mutual funds, but they may take three times as long as necessary to do it. Advisers who are paid a percentage of assets under management may advise against cashing in that stock fund to pay off student loans or mortgages. Commissioned brokers may find good reasons for recommending the products that pay them most. In most cases, says Cain, professionals aren’t even aware that their financial interests are affecting their advice, and probably have faith in their own recommendations. “Smart people always find reason to believe their own side.”

4. Everybody has homework, too
Even if you want to hire someone else to make your investment decisions for you, you still have to vet them. So learn as much as you can about how they do business and, decide before you hire them whether you are comfortable with the way they earn  money and the way they approach investment decisions. Then — ahem — read all of their disclosures.


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A clear breakdown of the actual dollar amount going to the adviser is a good start and no legalese or a hypothetical.

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