Broker-Dealers and Investment Advisers: A Behaviorial-Economics Analysis of Competing Suggestions for Reform

For the average investor trying to save for retirement or a child's college fund, the world of investing has become increasingly complex. These retail investors must turn more frequently to financial intermediaries, such as broker-dealers and investment advisers, to get sound investment advice. Such intermediaries perform different duties for their clients, however. The investment adviser owes his client a fiduciary duty of care and therefore must provide financial advice that is in the client's best interests, while the broker-dealer must merely provide advice that is suitable to the client's interests-a lower standard than the fiduciary duty of care. And yet these divergent standards are not necessarily evident to the average investor. As a result, investors run the risk of being placed into suboptimal investments by broker-dealers.Two competing solutions to this issue have been proposed: a higher fiduciary standard for both broker-dealers and investment advisers and a less burdensome disclosure standard in which broker-dealers would inform their clients that they are not fiduciaries. This Note analyzes these potential reforms using a traditional economics analysis as well as new behavioral-economics research. It concludes that a fiduciary standard more effectively protects investors and that a disclosure standard would actually have the perverse effect of making investors more susceptible to behavioral biases that can impair their ability to invest properly.IntroductionPeople often must rely on the relative expertise of others in making deci- sions. People rely on the advice of a waiter for good dishes at a restaurant, and they rely on their doctor to recommend a course of treatment when they have fallen ill. These situations are different, of course, but they both present a person with the fundamental decision of whether to trust another person's relative expertise. Such interactions are ubiquitous and unavoida- ble. They are also beneficial, because they save time and promote effi- ciency- just imagine having to learn every skill needed to make these decisions. Similarly, investors rely on expert advice when consulting their financial advisers. For example, retail investors, who are investing to save for retirement, college funds, or a home purchase, often possess little knowledge of investment strategies or products and therefore must trust others to help them make these decisions.1Investment advisers and broker-dealers both provide retail investors with expert financial advice. Despite this similarity, however, investment ad- visers and broker-dealers operate under very different regulatory regimes governing their relationships with their clients. Moreover, they have differ- ent financial incentives, which often diverge from the interests of their cli- ents. But neither of these differences is readily apparent to retail investors, who consequently do not understand how the differences impact them.2 In- vestment advisers are bound to offer investments that they believe are in the best interests of their client, and they are generally paid a fee regardless of whether the client buys or sells a particular investment. As a result, invest- ment advisers do not have any incentive to "sell" the investor on particular financial products.3 Not so with broker-dealers. They are bound only to find investments that are suitable for their clients-a lower standard-and they are generally paid commission on the sale of a financial product. Conse- quently, they have incentives to sell such products.4 Even though these prod- ucts are suitable for clients, they may not be optimal for their investment needs. This reality stems in part from the fact that broker-dealers' commis- sion on a product is tied to its riskiness, which means that a riskier product yields a higher commission, a situation that creates divergent incentives for broker-dealers and their clients.5These two financial intermediaries have different standards of care with respect to their clients. …