Gustavo Manso, Maurice F. Strong Career Development Professor of Management; Associate Professor of Finance
CAMBRIDGE, Mass., July 6, 2010 — For unsophisticated investors trying to decide where to put their money, there are no easy answers. Not only are there thousands and thousands of funds on the market, financial services companies have made their products so complicated that it’s hard for these investors to discern exactly what they’re signing up for.
“Financial services firms overcomplicate their products to maximize profits; the more they confuse investors, the more money they make,” says Gustavo Manso, Professor at MIT’s Sloan School of Management, who has done new research* on the topic.
This purposeful obfuscation on the part of financial services firms and lack of investor sophistication was one of the root causes of the recent economic crisis, he says. “Homeowners didn’t appreciate the variable-rate clauses in their mortgages, and customers didn’t understand the fees and interest rate schedules of their credit cards. Companies put all that information in the fine print and now we’re dealing with a record amount of household debt and a growing number of personal defaults in the US,” he says. “What to do about the disparity between sophistication and complexity has been getting a lot of attention lately, but the trouble is that every potential solution—be it financial education programs, regulation, or even a government-approved investment option—has its costs.”
Many policymakers and pundits have called for an increase in financial literacy programs, which could come in the form of high school courses, or publicity campaigns urging investors to seek out information from independent websites.
These programs may not have the desired effect, however. “When people talk about this initiative, they don’t think about the response on the part of the firm,” says Manso. “If we make everyone a little bit more educated, a little bit more sophisticated, we could make the problems worse because firms will respond by intentionally trying to confuse investors even more than they were before.”
The additional complexity introduced by financial services firms as a response to a slightly more educated investor population has three big costs: First, financial services firms need to spend money and effort to obfuscate in new and different ways—inventing new fee structures, or periodically swapping out fund managers, so that only sophisticated investors are able to keep up. This is money firms could spend in other, more positive ways, such as job creation or financial innovation.
Second, sophisticated investors will be forced to put more effort into keeping tabs on the new ways in which the companies are trying to mislead them. This is time and money they could spend on other things. Third, as the complexity level of these products rises, many investors will stay out of the market by, for example, opting for a basic bank account instead of investing in mutual funds. Losing out on stock market returns could have a dire result on their life savings.
Alternative solutions have drawbacks as well, says Manso, who collaborated on the research with Bruce Ian Carlin of UCLA’s Anderson School of Management. Regulation, such as the financial overhaul bill hammered out late last month, gives a lot of power to the government to restrict what a firm can and cannot do, and may limit financial innovation.
Meanwhile, offering investors government-recommended default options for, say, their 401(k) plans, undermines social learning. “When investors are doing their asset allocation for their 401(k) plans, they ask their friends and colleagues about the best mutual funds; there’s a social learning that goes on between unsophisticated and sophisticated investors,” he says. “But if the government introduced a default fund and people herded into it, it could have a negative effect. There would be no more social learning.”
Manso says his research shouldn’t necessarily discourage those seeking a solution. “The point is there are trade offs,” he says. “We have to look at each option: Is it possible to devise regulation that allows for periodic revision of the rules so that it won’t limit financial innovation? Can we change the parameters of financial education initiatives? Can we look at how important social learning is to our welfare?
“Our goal in this research is to point out the different tradeoffs and costs of solving this problem. We then need to think about which answer is the best one.”
* Obfuscation, Learning, and the Evolution of Investor Sophistication by Bruce Ian Carlin and Gustavo Manso