Author Archives: Antoinette Schoar

What Your Credit-Card Offers Say About You

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credit_card_finances_gettyAs more and more personal data becomes available, businesses are now able to target customers in a personalized and sophisticated way.  On the bright side, that means you can get products and services that are tailored to your needs. As a result, you are much less likely to get catalogs featuring dresses your grandmother might wear. But, according to our research, the downside is that companies can also more effectively target your behavioral weaknesses, self-control issues or lack of attention to the fine print. We find that credit-card companies tend to offer those customers who are least able to manage the complexity of credit-card contracts, the most complex features and hidden charges.

As part of our research at MIT with my colleague Hong Ru, we recently studied over one million credit-card mailing campaigns that were sent to a representative set of U.S. households from March 1999 to February 2011. We devised algorithms to classify the terms of the credit cards and also the advertising material. Studying the wide variety of offers and who received which offer was illuminating. Credit-card terms offered to more financially sophisticated consumers differ significantly from those offered to less sophisticated customers, where educational attainment served as a proxy for sophistication.

The offers differed in both substance and style.  Less-sophisticated borrowers received offers with low teaser rates, more rewards, visual distractions, and fine print at the end of the offer letter. However, these offers also had more back-loaded and hidden fees. For example, after the introductory period, these cards have higher rates, late fees and overlimit fees.

In contrast, cards that are offered to sophisticated customers rely much less on back-loaded fees and instead have higher upfront fees, such as annual fees.  These cards tend to have higher regular annual percentage rates and often carry an annual fee, but they have low late fees and over-the-limit fees and are more likely to carry airline miles as rewards.

Not surprisingly, the worse the credit terms, the more likely they are to appear either in small font or on the last pages of the offer letters.  Similarly, offer letters with back-loaded terms contain more photos and less text, perhaps to distract from the details of the offer—what we refer to as shrouded attributes.

In fact, we found that banks seem to carefully monitor how the use of such shrouded attributes might affect the likelihood that unsophisticated customers will default on their debts. Our study showed that less-educated consumers who have lower default risk are more subject to back-loaded or shrouded fees. We also found that in states where there was an increase in unemployment insurance benefits that help borrowers maintain more stable cash flows in the event of a job loss, banks issued potential borrowers within that state more offers with lower teaser rates but higher late fees and default penalties. Banks also increased the flashiness of the offer letter, with more colors and photos, but moved the information about the back-loaded features to the end of the letter.

Taken together, these results suggest that credit-card companies realize that there is an inherent trade-off in the use of back-loaded features in credit-card offers: They might induce customers to take on more (expensive) credit, but at the same time, they expose the lender to greater risk if those consumers do not anticipate the true cost of credit.

So what’s the upshot of our study? First, you are lucky if you have a good education, since it means that the set of credit cards you get to choose from is already better from the start. But independent of your educational status, consumers should know that they have the power and information to choose well. Each credit-card offer in the U.S. must by law have a text box that contains all the relevant terms of the offer in one place; this is called the Schumer box after Sen. Chuck Schumer of New York.

So the best way to choose a credit card is to literally throw away all the marketing material at the front of the offer and simply focus on the real information in the Schumer box. This is true no matter what your income or education level.

Antoinette Schoar is the Michael Koerner ’49 professor of entrepreneurial finance and chair of the finance department at the MIT Sloan School of Management.

How expensive is good financial advice?

Professor Antoinette Schoar

The last two decades have seen a rise in the number of defined contribution plans such as 401(k) plans. As of 2011, Americans held $4.7 trillion in IRAs and defined contribution plans alone. These plans require ordinary citizens to make extremely complex investment decisions as they plan for retirement. For example, they must decide how much of their portfolios to put into stocks and how much to invest in bonds, the amount of risk to take, the right investment horizon, how often to rebalance their portfolio, and so on. The financial service industry offers people a myriad of choices and products. In the US, there are more than 22,000 class shares and 7,000 mutual funds with many different investment styles, rebalancing options, fee structures, and other features. The structure of funds has almost become more complex than the assets themselves.

So how can investors navigate the increasingly complex landscape of investment choices? Many people (as many as 73 percent, according to one survey by the RAND Institute) seek professional assistance before making investment and savings decisions. However, even the choice of finding the right assistance involves significant complexity. There are 270 financial services designations with wide-ranging educational requirements and regulatory standards, and most private investors don’t know how to differentiate one from another. Investors often find their way to professionals who loosely call themselves “advisors” or their services “financial planning,” though they are de facto sales agents paid commissions by their company. This pay structure can lead to conflicts of interests between financial professionals and their clients, ultimately reducing the returns that clients accumulate in their portfolios.

Despite a wealth of anecdotes that fee structures influence investing advice, there is little reliable evidence about the quality of advice that financial professionals actually provide. Do financial professionals help retail investors make better financial decisions and educate investors about their mistaken beliefs? Or do they put their own interests first and attempt to generate more commissions and fees?

To find some answers to questions such as these, I partnered with Professors Sendhil Mullainathan of Harvard University, Markus Noeth of the University of Hamburg, and ideas42, an applied behavioral economics lab, to do an audit study of the investment advice industry for retail customers. We sent more than 40 trained mystery shoppers on multiple visits to over 100 different financial service providers, including retail firms, banks, and independent advisors throughout the greater Boston area. (We repeated this approach in 2011 in both the NYC and Boston markets.) We hired men and women who represented people of different income levels, ages, and portfolio sizes in order to assess how well advisors responded to the needs of different kinds of clients.

Most importantly, we randomly varied the type of investment strategy represented in these mystery shoppers’ portfolios. The strategies that were based on harmful biases about investing varied in how much money they could cost the clients if not corrected, and whether or not they created conflicts of interest between financial professional and client.

For example, some mystery shoppers presented financial professionals with an investment strategy that is often called “returns chasing,” or investing in “hot” sectors that have recently done well. Finance research has shown that this is a bad investment strategy. Returns in the public equity market are not predictable on average; an industry that did well in the last quarter is not guaranteed to do well going forward. However, the strategy benefits financial professionals paid on commissions, since it encourages clients to move their money in and out of funds frequently, generating fees each time.

In contrast, we assigned another group of mystery shoppers a portfolio that was heavily invested in their employer’s stock. In this case, the interests of client and financial professional were aligned. Many financial professionals can generate fees by moving client funds out of this stock, and clients benefit too, since over-investing in company stock leads to severe under-diversification and risk.

The results of our audit were not terribly encouraging for investors. First, we find that self-interest played a very important role in the quality of advice provided. The majority of financial professionals were particularly supportive of investment biases that helped them maximize their commissions and fees while being less encouraging of strategies recommended by textbook finance research for maximizing returns. Most strikingly, the professionals were particularly discouraging of low-fee investment strategies like index funds, which finance research has found to be a superior investment option. In fact, many of the financial professionals encouraged clients to move money out of low-cost index funds into higher-cost alternatives. These professionals’ recommendations could collectively cost investors hundreds of thousands of dollars in forgone returns over time. It should be noted that there was no sign that financial professionals were doing anything illegal or violated existing regulations, since the behavior of financial professionals is very lightly regulated.

So what can investors do in order to find better advice and avoid preventable missteps? First of all, investors should check the credentials and education levels of the professionals from whom they seek assistance. Investors should search in particular for professionals held to a fiduciary standard, such as Certified Financial Planners, who are obligated by law to offer advice in their clients’ best interests. Also, investors should investigate the compensation structures and fees associated with any advisory relationship. While many financial professionals receive commissions that may create a conflict of interest, others charge a flat fee or a fixed percentage of the money they manage. These structures are much better for the investor since they incentivize the investment professional to grow the investor’s portfolio.

However, investors also need to check their own expectations before going into these investment decisions. They are often lured by “siren songs” of astronomical returns without much effort, because it is less pleasant to hear that they cannot rely on uncommonly high returns while avoiding the burden of saving for retirement. In fact, if investors approach financial professionals with such overblown expectations, then financial professionals may feel pressure to recommend less prudent strategies just so they can keep their business. Hence, the most important thing investors can do is to be open to prudent advice. If an investment strategy sounds too go to be true, it usually is.

Antoinette Schoar is the Michael M. Koerner (1949) Professor of Entrepreneurship and teaches in the areas of entrepreneurial finance and corporate finance at MIT Sloan School of Management.