What we all feared: 'Better' disclosure yields worse results, according to Yale professor's study

At an exclusive think-tank style conference on the Potomac, industry leaders heard the psychology behind investors' rosy view of the world.

Sunday 9.26.10 by Elizabeth MacBride

Brooke’s Note: The only good news about this damning indictment of investor-protections-by-thicker-sheaves-of-disclosures is that many of the right people were present on Friday to hear about it. Those assembled included key legal and regulatory personnel from companies like LPL and Fidelity and organizations like the SEC. The RIA world was represented by no less than Harold Evensky and Ron Rhoades. On the other hand, I’m unclear why anyone thought disclosures worked well in the first place. Nobody I know stopped smoking because it was disclosed on the side of the cigarette pack that it was hazardous to their health.

Advisors who disclose their conflicts of interest actually deliver advice that is twice as bad as the advice they would give if they didn’t disclose, according to a Yale University professor who has been studying the effects of disclosure on investor behavior.

Disclosure appears to give the advisor emotional license to guide investors toward whatever outcome benefits the advisor, said Daylian Cain, assistant professor of organizational behavior at the Yale School of Management.

At a think-tank-like conference in Washington, D.C., attended by a cross-section of industry leaders, Cain and Robert Prentice, associate chairman of the McCombs School of Business at the University of Texas at Austin, reported finding after finding that disclosing conflicts of interest does little if anything to protect investors – and may even hurt them. The question of how well disclosure protects investors is critical now, as the SEC considers how to write regulations that would cover investment advisors and broker-dealers – and, it’s hoped, protect investors in a financial system that is rife with conflicts of interest.


The findings were “sobering,” said Rich Hannibal, assistant director for broker-dealers in the Office of Compliance Inspections and Examinations for the SEC.

“I’m rethinking my thinking on disclosure after this afternoon,” ruefully said Stephanie Brown, general counsel of LPL Financial Corp., the largest independent broker-dealer. “I’m a securities lawyer. I thrive on disclosure.”

They were two of about 100 people present at the conference, called Fiduciary Forum 2010, put on by the Committee for the Fiduciary Standard and other industry groups. Lawyers, regulators, advocates, academics and industry leaders gathered to explore the question of how the fiduciary standard might realistically be applied to broker-dealers.

Among those present were Gilbert Ott, general counsel of TD Ameritrade, David Canter, executive vice president of Fidelity Institutional Wealth Services, Harold Evensky, president of Evensky & Katz, considered a sort of godfather of the RIA business, and Martin Durbin, president of Fort Worth, Texas-based First Command Financial Services, which has an $18 billion RIA.

Leading securities law experts Tamar Frankel, a Boston University School of Law professor, and Arthur Laby of the Rutgers School of Law also spoke.

The conference was held just a few blocks away from the SEC headquarters, where the staff is busy working on a study about how to create a regulatory system that would apply both to investment advisors and broker-dealers. One strong possibility – indeed, the one that’s being urged by broker-dealer advocates – is that new regulations could be built on the principal of disclosure.

Gray zone

For instance, selling a proprietary fund with significantly higher costs than another non-proprietary fund would still be OK – if the costs and the conflict of interest were disclosed. The SEC generally has taken the position that disclosure can’t excuse harm – but any new regulations could use disclosure as a rationale for many practices that fall into the gray zone.

Many RIAs now rely on the disclosure to give advice that might otherwise be questionable under the fiduciary standard that calls for RIAs to act in their clients’ best interests. Brian Hamburger said some of his clients like to throw in everything but the kitchen sink into their disclosures.

Disclosure is seductive, said Cain and Prentice.

“It has become particularly appealing to regulators,” Prentice said. “It’s easy. It’s cheap.”

“The industry loves disclosure,” Cain added, “because if anybody knows it doesn’t work, it’s them.”

Among the other conclusions the two academics offered about disclosure and how incapable investors are of navigating a system in which their brokers and advisors don’t necessarily have their best interests at heart:

Don’t read

  • Most investors don’t read written disclosures, Prentice said, pointing out that about 40 million Americans are illiterate and 50 million more have marginal skills. Even those that are among the most educated don’t read the reams of fine print that accompany financial products. “I sign contracts all the time that I don’t read,” said Prentice, who also pointed out that the Truth in Lending laws that require extensive disclosures did not protect consumers whose mortgage borrowing helped bring on the financial crisis.
  • Oral disclosures are more effective than written ones, Prentice said.
  • People have a strong bias to be more positive than is realistic – they have a “personal positivity bias.” This bias causes them to ignore disclosures and conflicts of interest. People tend to be over-confident and to believe that contracts are better than they are, Prentice said. “A majority of people think they are better than average. The only people who are really well-calibrated are the chronically depressed.”
  • Cain did one study that look at four advisors, with two that were honest and two that had a conflict of interest. They were offering advice on lotteries that were structured advantageously or not for investors and advisors. Cain found that advisors with conflicts give worse advice. He said this can happen even while advisors sincerely believed they were giving good advice. “You believe your own side,” Cain said.
  • The advisors that disclosed the conflict gave even worse advice, steering investors toward an investment that benefited the advisor more, Cain said.

Helping out the hungry broker

  • Disclosures did not usually give investors pause. Sometimes, Cain said, investors were apt because of a human connection with the advisor to feel that they should help the advisor out, even if it meant lowering their own return. Also, people want to believe they are too smart to be cheated. “We all try hard not to distrust people,” Prentice said, bringing up Madoff case. “Really, really intelligent, rich, experienced people had one piece of evidence after another that Bernie Madoff’s returns were too good to be true,” he said. “They wanted to believe so much.”

The co-sponsors of the event included the Certified Financial Planner Board of Standards, the Financial Services Institute, the Financial Planning Association and the National Association of Personal Financial Advisors.

Brian Hamburger | Tamar Frankel | Robert Prentice | Arthur Laby | Stephanie Brown | Daylian Cain

SEC | LPL | MarketCounsel | Committee for the Fiduciary Standard | Yale School of Management