The mineral Pyrite, an iron sulfide, features a rich metallic luster with a color that resembles a brassy yellow. With these traits, prospectors often mistook Pyrite for gold, resulting in its nickname "fool's gold."
In the tussle between industry combatants, the fight for the fiduciary standard comes down to one word: Disclosure. The SEC has made no question of the importance of disclosure when conflicts of interest exist.
One need only look at the format of the new ADV Part 2. Replete with the term "fiduciary," the SEC's instructions implicitly demand Registered Investment Advisers to fully disclose how their actions measure up to the duties of a fiduciary. A fine and honorable concept, one wonders how many RIA clients and prospects will actually read the darn thing, especially now that the SEC has determined it's better for RIA's to provide a "plain English" novella as opposed to the simple and easier-to-read few pages of the previous ADV Part II.
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Aye, there's the rub. It's so easy to make sure all the i's are dotted and the t's are crossed. Financial service providers like disclosure because it allows them to continue business-as-usual when it comes to conflicts of interest. Financial regulators like disclosure because it addresses political/consumer concerns with the facade of "transparency." Everything's perfect in the world, right? After all, there's gold in them thar disclosures.
But what if our quest for disclosure represents nothing more than a fool's rush? This is precisely what academic research suggests.
The Committee for the Fiduciary Standard sponsored the Fiduciary Forum last fall. The featured speakers included Daylian M. Cain, Assistant Professor of Organizational Behavior at the Yale School of Management. While Cain spoke well of transparency, his pioneering research in behavioral economics warns, rather than acting as the panacea regulators hope for, disclosure may actually harm investors. (For more information, see "Exclusive Interview with Yale's Daylian Cain: Just a Sugar Pill? Disclosure's 'Ah-Ha!' Moment" Fiduciary News, October 23, 2010.)
How is this so? Recall for a moment the Prisoner's Dilemma. In this famous game theory puzzle two suspects are separated and asked to rat on their co-conspirator. If neither talks, they both serve a minor sentence of a few months. If they both testify, they each get five years. If one talks and the other doesn't, the talker goes free and the fingered fellow gets the book thrown at him and a decade-long sentence.
Imagine what goes on in the minds of the suspects if the cops reveal nothing to them. They'll probably both keep their mouth shut – the best outcome for the twosome.
Now, think what happens when the interrogators disclose to the prisoners the exact nature of the dilemma. With the lure of freedom – and the harsh punishment silence brings when the other talks – the prisoners almost invariably make the worst choice: they both talk.
Cain's research evokes such behavioral terminology as "anchoring" and the "panhandler effect." Anchoring refers to sticking points that impact decision making, even when those sticking points occur randomly. The panhandler effect alludes to the guilt one feels when passing a panhandler. That guilt makes you comply with the panhandler's request. Ironically, research shows disclosure may compel investors to take bad advice because they feel sorry for the person giving the advice.
Other researchers have found repeated disclosures with sanctions for giving biased advice might eventually prove fruitful in the case of institutional investors like 401(k) plan sponsors, but, says Cain, "the jury is still out." He's worried, despite properly trained institutional investors, savvy service providers will still find ways to provide manipulative advice. Cain feels years of social science research suggests once we open Pandora's Box of conflicted advice, it's hard to put that Genie back in the Bottle.
Cain's Journal of Consumer Research paper "When Sunlight Fails to Disinfect: Understanding the Perverse Effects of Disclosing Conflicts of Interest," (with G. Loewenstein and D. A. Moore), shows the mere availability of unbiased advice will not suffice. Clients lack the motivation to consider alternatives even when presented with damning disclosures. So, if the purpose of disclosure is to protect investors, the SEC and the DOL might want to read this paper – one might even say it's their fiduciary duty to read it.
After all, shouldn't we be sure disclosure is the real thing and not just regulatory pyrite?
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