From The Wall Street Journal
The world we live in asks us to make an abundance of financial decisions every day. These range from the inane, such as whether to risk a parking ticket when you stop for one minute to drop off your dry-cleaning; to the highly complex, such as which funds and investment products to pick for your retirement savings.
All of these decisions require risk-return tradeoffs. Unfortunately, while people have many opportunities in life to perfect their strategy concerning parking tickets, the same is not true for the complex and all-important decisions of how to invest retirement savings. By the time you learn whether a retirement strategy was the right choice, it is usually too late to change it.
Not surprisingly then, much research shows that a large fraction of the population is poorly prepared to make these financial decisions by themselves. Typically, when faced with complex and important decisions we rely on trusted experts for advice. Sick people turn to doctors, those accused of crimes seek the help of lawyers, and the list goes on. These cases all have a common feature: The expert adviser must abide by a strict code of conduct that puts the interest of the client first.
Surprisingly, the same is not always true for financial experts who advise people on their retirement savings. A majority of these professionals are not registered as financial advisers who have a fiduciary responsibility to their clients, which means putting their clients’ interest first. Instead, they are registered as brokers who only adhere to what is known as a “suitability” standard, which is much vaguer and only asks brokers to make recommendations that are consistent with the client’s interest.
In addition, the majority of brokers are not paid on the basis of the quality of their advice, but rather on the fee income they generate from their clients. To resort to a medical analogy, this is equivalent to simply prohibiting doctors from recommending drugs that kill you, while not actually requiring they prescribe the best drugs to cure your disease.
Antoinette Schoar is the Michael M. Koerner (1949) Professor of Entrepreneurship and Professor of Finance at the MIT Sloan School of Management.