Disclosure Won't Stop A Conflicted Advisor

Monetary Conflicts

Nowhere are conflicts of interest quite so common as in the financial industry. Accountancy firms want to provide consulting services, credit rating agency employees want to work for security analysis firms, independent security analysts need to ensure their recommendations don’t lose their employers important mandates, financial advisors want to get commissions for recommending products ... the list is almost endless.

The popular answer to these problems is almost always the same – disclosure of the conflict of interest so that the purchaser is fully aware of the potential problem. Unfortunately the reason that disclosure is so popular is that it doesn’t work. Even worse, it may actually make the problem worse.

Corruption’s Not The Problem

Let’s start this sad catalogue of problems with an important caveat. In almost all instances the problems caused by conflicts of interest between personal interests and professional ones are not cases of corruption. Of course there are some advisors who are blatantly dishonest and who deliberately oversell their products but these are relatively few and far between and besides aren’t the topic of our investigation. No, our bunch of conflicted advisors are driven by internal demons that are far more difficult to pin down. These are unconscious side-effects of various psychological biases rather than deliberate acts of criminal intent.

In the end most corrupt advisors get rumbled – although as Bernie Madoff has shown, this may take an awfully long time. The problem with the honest ones is that they’re still chiselling us yet would be able to fool a lie detector or, worse, their wives, without the slightest difficulty. Meanwhile the methods used to protect us from these practices may actually make things worse.

Disclosure or Regulation?

The most popular remedy to conflicts of interest is disclosure. The idea is that if the advisors, of whatever hue, declare their conflicts then we, the purchasers, can make a clear sighted call about whether the advice we’re being given is in our best interests. However, we can almost immediately identify two problems with this. Firstly, if we were really able to make such decisions then we wouldn’t need to consult an expert anyway. Secondly, even if we do adjust our behaviour to take account of the conflict we have no guarantee that the advisor won’t adjust theirs to take account of the fact we know about the conflict.

And if you didn’t get that don’t worry. We’ll get back to it soon enough.

The alternative to disclosure is often regulation, making the disclosed behaviour illegal. Mostly the affected parties prefer disclosure since this avoids them having to give up whatever they’re disclosing and also means that all parties don’t have to adjust to a difficult new reality. However, the idea behind disclosure is actually pretty dubious: it shifts the responsibility for making informed decisions from the (supposedly) knowledgeable advisor to the (usually) uninformed client.

The Dirt on Coming Clean

Cain, Loewenstein and Moore investigated this whole area in The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest and anyone really interested in this topic should peruse the source material as it’s impossible to do it justice in a short article. It's a very fine piece of research.

They took the basic idea of disclosure into a laboratory setting and set about developing an experiment to investigate its effects on advisors and clients. By comparing advisors' own personal estimates with the advice they actually gave under different conflicted situations they found that:

1. If advisors don’t have any conflicts of interest their advice is unbiased;
2. If advisors do have conflicts of interest but don’t disclose them then their advice is biased;
3. If advisors do have conflicts of interest and do reveal them then their advice is even more biased.

Trying to disentangle the various threads involved in this is tricky but two possible explanations have been proposed. The first is simply that the disclosure of conflicts of interest leads advisors to assume that clients will discount their advice, so they increase the bias in their advice to compensate. The second is that the disclosure frees the advisor from guilty feelings about violating professional norms and this so-called “moral licensing” leads to more bias.

There was another problem, though. Although clients discounted their advisors’ opinions when the conflict was disclosed this was insufficient to offset the bias. Which led to even less accurate decisions than when the conflict was undisclosed.

Clients Are Also Conflicted

So this is a two-way street: clients are also affected by advisor disclosure, only not necessarily in the way you might expect. Other research has found that disclosure doesn’t necessarily deter clients from accepting advisors’ advice and may actually have the opposite effect. Two underlying biases seem to be implicated in this. Firstly we have a tendency to delegate difficult decisions to experts – so, for instance, we generally accept the opinions of our doctors without ever asking for a second opinion (a mistake, by the way). So the fact that we’re being told that the expert has a conflict of interest often doesn’t make much difference – the expert is the one in charge.

Secondly, the disclosure inadvertently seems to trigger a response that works along the lines of “if they’re told me about this conflict then that shows that they’re honest and if they’re honest then I should trust them more”. The fact that the honesty has been forced upon the advisor by a legal requirement to make the disclosure is irrelevant, it seems. It’s the disclosure that triggers the response.

Expert Evaluation of Expert Disclosure

Possibly the biggest problem, however, is that a disclosure of a conflict of interest by an expert often requires an expert to evaluate it. If you go to a doctor about a difficult medical problem and the physician tells you that you need an expensive drug but that she’s being paid by the pharmaceutical industry to plug it how do you respond? Does this disclosure help you make the decision or not?

Well, not, as it happens.

If you can’t trust the expert giving you advice then possibly your only option is to get another expert opinion. However, the evidence from medical research is that people don’t bother. This is possibly more worrying in finance than medicine. As Bill Bernstein has said:

"The depressing fact of the matter is that the federal and state governments do not protect investors in the same way that they do the clients of other professions. Amazingly, stockbrokers are not considered fiduciaries at all, as are practitioners of all other learned professions. This state of affairs is, in some respect, a historical accident.

All the professions I've mentioned, except finance, have long since recognized that regulation of minimal standards of training and practice is a necessity. It happened, for example, to the medical profession a century ago with the publication of the Flexner Report. Bluntly put, there's no chance that your doctor, dentist, or attorney is a high-school dropout. Your stockbroker, however, just might be."

After all, what is a financial expert anyway?

You Get What You Pay For – One Way Or Another

Disclosure’s a lousy way of fixing the kind of problems caused by conflicts of interest. It seems that business models that rely on promoting such conflicts are fundamentally flawed because they’re bound to trigger this type of behavioural confusion. In fact, wherever you find a situation where disclosure is mandated you should automatically assume that you're at risk from these types of unconcious bias. As my grandmother used to say: you get what you pay for. Even if you don’t know you’re doing so.

The research says, that when it comes to advice, especially in financial matters, it’s always safest to pay directly rather than indirectly. Alternatively, get a second opinion.


Related Articles: You Can't Trust The Experts With Your Investments, Bulletin Boards Are Bad For Your Wealth, Survivorship Bias In Magical Mutual Funds