The world we live in asks us to make financial decisions every day. These range from the inane, such as whether to risk a parking ticket when you stop for one minute to drop off your dry-cleaning, to the highly complex, such as which funds and investment products to pick for your retirement savings.
All of these decisions require risk-return trade-offs. Unfortunately, while people have many opportunities to perfect their strategy concerning parking tickets, the same is not true for the complex and all-important decisions of how to invest retirement savings. By the time you learn whether a retirement strategy was the right choice, it is usually too late to change it.
Not surprisingly then, much research shows that a large percentage of the population is poorly prepared to make these financial decisions on their own.
Typically, when faced with complex and important decisions, we rely on trusted experts for advice. Sick people turn to doctors, those accused of crimes seek the help of lawyers, and the list goes on. These cases all have a common feature: the expert adviser must abide by a strict code of conduct that puts the interest of the client first.
Notably, the same is not true for experts who advise people about their investments.
Many of these professionals are not registered as financial advisers with a fiduciary responsibility to their clients, which means putting their clients’ interest first. Instead, they are registered as brokers who adhere to what is known as a “suitability” standard, which is more vague and only asks brokers to make recommendations that are consistent with the client’s interest.
In addition, the majority of brokers are not paid on the basis of the quality of their advice, but rather on the fee income they generate from their clients. To resort to a medical analogy, this is equivalent to prohibiting doctors from recommending drugs that kill you, while not actually requiring they prescribe the best drugs to cure your disease. Moreover, this would occur in a world where doctors are paid based on the sales generated by their prescriptions. People would be highly concerned to entrust their health to such a doctor.
In a study with my coauthors Sendhil Mullainathan at Harvard and Markus Noeth at Hamburg University we set out to analyze the quality of financial advice commonly given to clients. We sent “mystery shoppers” to financial advisers and brokers in the greater Boston area who impersonated regular customers seeking advice on how to invest their retirement savings outside of their 401(k) plans. The mystery shoppers also represent different levels of bias or misinformation about financial markets.
What we learned is highly troubling. By and large, the advice our shoppers received did not correct their misconceptions. Even more troubling, the advice seemed to exaggerate the existing misconceptions of clients if it made it easier to sell more expensive and higher fee products.
In addition, brokers strongly favored actively managed funds over index funds. In only 7.5 percent of sessions did they encourage investing in index funds. This is exactly counter to insights from finance research, which suggests that the average investor should choose low-cost index funds over actively managed funds. If fees were mentioned at all, they were usually downplayed in their importance. Financial advisers with fiduciary responsibilities had slightly better performance, since they were more likely to suggest investing in low cost index funds to their clients.
Of course, no one expects financial advisers or brokers to work pro bono. But what is alarming is that incentives seem to be set in such a way as to move clients away from the existing strategy regardless of its merit, i.e., even when they looked at a low-fee-diversified portfolio. As a result, we found that clients end up with worse investment choices, since brokers and advisers are trying to secure financial gain for themselves. This is bad news for savers — including the many baby boomers — seeking to boost their retirement nest egg.
The Obama administration has proposed tighter fiduciary standards to which the investment advice business should be held. Our research suggests that this policy change would be beneficial. Indeed, we found that advisers who have a fiduciary responsibility towards their clients provide better and less-biased advice than those who are only registered as brokers. The former are less likely to move people away from index funds and to reinforce erroneous beliefs about the market.
There is an important additional benefit to a policy that reduces conflicts of interest between clients and their advisers. It also helps in harnessing the market’s competitive forces to the benefit of consumers.
As many financial advisers will point out, if retail investors are poorly informed, advisers who do provide sound financial advice often find it difficult to compete. A striking example is the story of John Bogle, the founder of The Vanguard Group, who introduced index funds to the U.S. market. Rather than rapidly gaining market share with his superior product, Bogle initially struggled mightily and his firm almost went out of business — without proper advice, consumers found it difficult to understand the positive features of index funds.
Holding financial advisers and brokers to higher fiduciary standards is not only good consumer financial protection, but also good market economics. As such, it should have appeal to a wide range of the political spectrum.
This article originally appeared on MarketWatch.com and is reprinted by permission from Marketwatch.com, ©2015 Dow Jones & Co. Inc. All rights reserved.