Swedroe: Fiduciary Duty Defeats ‘Phishing’

Classical economic theory suggests that free markets, in which individuals each act according to their self-interest, yield the best of all possible worlds. All one has to do is look around at places like Cuba and North Korea to see the benefits this system has provided.

But economists George Akerlof and Nobel Prize-winner Robert Shiller present a very different side to this story in their book, “Phishing for Phools.” (The “phish” is a way to get someone to make a decision that’s to the benefit of the phisher, but not to the benefit of the “phool.”) The authors observe: “Modern economics inherently fails to grapple with deception and trickery.”

Akerlof and Shiller aptly demonstrate that the “same human ingenuity that produces the cornucopia also goes into the art of the salesman.” The result is that as long as there is a profit to be made, while “free markets produce good-for-me/good-for-you’s, they also produce good-for-me/bad-for-you’s.” Thus, they conclude: “That means we need protection against the problems.”

The authors go on to give us many examples showing that “every man has his weak spot, and so every one of us is oftentimes less than fully informed; and oftentimes we have difficulty knowing what we really want. As a by-product of these human weaknesses, we can be tricked.”

While they are still admirers of competitive free markets, Akerlof and Shiller show that if markets were totally free, then they would become “not just … the playing field for providing us with what we need and want,” but also the pool in which phools are phished. Market participants would be caught in what the authors call a “phishing equilibrium.” The result is that, as long as profits can be made from phishing, it will occur. Just think of those emails with nasty viruses.

Phishing And Finance

The examples Akerlof and Shiller provide demonstrate how phishing for phools happens when we are buying cars, homes, food, even medicine, and with investment products as well.

They describe how phishing was one of the primary causes of the financial crisis of 2008. They also explore the “grave implications for social policy, including the role of government as a complement rather than a hindrance to free markets—since, just as our computers need protection against malware, so too we need protection against phishing for phools more broadly defined.”

Much of the book is about the field of behavioral finance, which has demonstrated that people frequently make decisions not in their best interests. As Akerlof and Shiller write, “Put bluntly, they do not do what is really good for them; they do not choose what they really want. Such bad decisions make it possible for them to be phished for phools.”

And there will always be phishers waiting to exploit them. The Enron accounting scandal is a great example of the fact that “as long as there are profits to be made from magicians playing tricks, the magicians will be there. That is the nature of economic equilibrium. And that is the reason why financial markets especially are in need of careful oversight.”

Chapter Summary

Chapter 3 outlines how advertisers discover ways to zoom in on our weak spots, and provides interesting case studies that show that “if you can divert the story someone is telling himself, in your favor, but not in his, you have ripened him up to be phished for a phool. Such diversion, of course, is a major advertising/marketing technique.” It happens to be a technique used not only by Madison Avenue but by Wall Street as well, especially in the design of such products as structured notes and variable annuities.

Chapter 4 is about how individuals can get ripped off on cars, houses and credit cards, while Chapter 5 is all about phishing and politics, including examples of how “in equilibrium phishing for phools significantly subverts democracy.”

Chapter 6 tackles “phood, pharm and phishing” and describes how “phisherman finesse regulations, as they have evolved ways to phish regulators rather than the public—for phools.” The tale of Merck and Vioxx is related as a great example.

Chapter 7 is about the good, the bad and the ugly of innovation, demonstrating that not all innovation yields invariably good outcomes. Just consider the creation of all the derivatives that allowed the financial crisis of 2008 to be much greater than it could have been otherwise. Both the book and the movie “The Big Short” showed how Wall Street phished the public and the ratings agencies for phools.

Chapter 8 is about the “sin” industries of alcohol and tobacco, and explains how people with addictive behaviors are phished.

And Chapter 9 is about using the bankruptcy code for profit. This chapter uses the exploits of Michael Milken, the junk bond king, to illustrate how phools were phished.

Ending on a higher note, the final chapter also discusses what the authors refer to as “the resistance and its heroes—idealists who draw attention to phishing, start social movements, and set in motion corrective forces.”

In Defense Of Fiduciary Duty

Akerlof and Shiller deliver an important message: As long as there is profit to be made, sellers will systematically exploit psychological weaknesses and ignorance through manipulation and deception. This is why it remains critical that Congress pass a law requiring that all financial advisors provide a fiduciary standard of care.

There’s no excuse for this not to happen. In my view, anyone voting against it either has been phished as a phool or bought off, because all the arguments thrown out by Wall Street are phony with no basis in fact.

For example, Wall Street wants you to believe that if a fiduciary standard was imposed, many investors would lose access to advice. But there is no shortage of RIAs around the country that provide a fiduciary standard of care.

In fact, broker-dealers have, for years, been persistently losing market share to RIAs as investors wise up. There are entire networks of fiduciary advisors standing ready to service smaller accounts. At least one of these networks has the goal of making competent and objective advice accessible through hourly, as-needed financial planning. What’s more, there is now an entire array of technology-based platforms that provide a fiduciary standard of care.

In addition, the whole argument about commission-based compensation being a necessary part of servicing smaller accounts is bogus. If you doubt that, then ask yourself why Wall Street doesn’t propose that commissions be allowed only on smaller accounts, say, less than $50,000 or $100,000?

Of course, they never would, as it would limit their ability to phish for the bigger and more profitable phools. The fact is that any commission paid in the form of revenue sharing can be converted into a fee paid by the investor.

Consider an investor with a relatively small portfolio, perhaps $50,000. A broker-dealer might recommend an actively managed fund with very high expenses because its sale generates a 4% commission ($2,000).

There might be a superior alternative, but it is not recommended, because there’s no revenue sharing. To eliminate the conflict of interest, the broker could simply charge an advisory fee of the same $2,000 and the investor would be better served. Of course, it’s likely that the investor could find quality advice for a lot lower fee!

How Much Does Fiduciary Duty Cost?

Another lie told by some in the brokerage industry is that a fiduciary standard of care would cost more. A recent study, “The Impact of the Broker-Dealer Fiduciary Standard on Financial Advice,” examined this issue. The authors, Michael Finke and Thomas Langdon, designed a study to take advantage of different state broker-dealer standards of care to determine if imposing a fiduciary standard was more costly.

They found there were no statistical differences between the two groups in the percentage of lower-income and high net worth clients, the ability to provide a broad range of products, the ability to provide tailored advice and the cost of compliance.

Bottom line: There is no evidence that a fiduciary standard is more expensive. Investors can obtain the greater accountability of the fiduciary standard without higher costs or reduced choices. It’s just that, if the fiduciary standard were imposed, brokers would make less money and investors would make a lot more.

I believe there is only one reason broker-dealers fight the fiduciary standard: It would eliminate the conflicts of interest that lead to brokers (the phishers) taking advantage of the information mismatch they have over investors (the phish). This mismatch allows them to extract excess “rents” from the wallets of investors.

It’s time the ability of broker-dealers to exploit naive and trusting investors comes to an end. There is simply no reason for not imposing a fiduciary standard, and there is certainly no reason for any investor not to demand it, regardless of what the law allows. If you are currently working with an advisor who doesn’t provide a fiduciary standard of care, you should ask why you are allowing yourself to be exploited.

Akerlof and Shiller’s book is perhaps the strongest argument for imposing the fiduciary standard of care on anyone holding themselves out to the investing public as a financial advisor. It’s certainly worth the investment of your time (and money) to read it.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.