In a now-famous 1970 paper, economist George Akerlof used the market for used cars to demonstrate the negative effects that can occur when there are significant information asymmetries between buyers and sellers of a good or service. He highlighted the market for used cars at the time, where, because consumers could not be sure of the quality of a used car they were offered, they were only willing to pay the price of a car in average condition, driving out sellers of high-quality used cars (“peaches”), who were not willing to accept the average price for their above-average product. At the same time, sellers of low-quality cars (“lemons”) were incentivized to enter the market, as they could receive a price greater than the actual value of their used car. This information asymmetry led to a negative cycle where more low-quality cars would enter the market, driving down consumer trust (and the price they were willing to pay) and even leading to a market of lower-quality cars.
The financial advisory industry is not immune to the same problems faced in Akerlof’s used-car market. Given the wide range of professionals who can call themselves ‘financial advisors’ – from someone whose business is selling insurance policies to a financial planner who sells financial advice itself – consumers can have difficulty understanding the type and quality of service they will receive from a given ‘advisor’. And just as the uncertainty of quality reduced the car buyers’ willingness to pay for high-quality cars in Akerlof’s analysis, the wide variance in advisor quality can also be likely to lead to a lack of trust among consumers.
But this also suggests that if standards in the market for advisors were raised (thereby increasing consumer trust), exceptional advisors could spend less money on differentiating themselves from advisors with lower standards, creating the opportunity for reduced marketing and business expenses that could be passed along in the form of lower costs for consumers (potentially opening up advice to a wider pool of clients!) and even allow for higher-quality advisors to enter the market. In fact, even a relatively modest shift to a higher-trust environment (which may be achieved by enacting higher standards) that just partially reduces the incredibly high client acquisition costs of financial advisors could more than offset the entire cost of fiduciary liability insurance from those higher standards!
In his paper, Akerlof suggests three strategies that could be used to counteract the effects of quality uncertainty and increase consumer confidence: licensing, quality guarantees, and branding. Accordingly, advisor licensing could mean establishing a requirement involving a professional designation like the CFP certification for those who provide financial advice. A quality guarantee could be implemented through a broad-based fiduciary standard (as advisors are understandably unable to offer outright performance guarantees), which can increase trust among consumers. And when it comes to branding, limiting the use of the title “financial advisor” and “financial planner” to those who are solely in the business of providing advice (rather than primarily selling products) and who meet certain competence and ethical standards would increase consumer confidence as well.
Ultimately, the key point is that information asymmetries that reduce consumer trust are common in the financial advisory marketplace, and raising industry standards of conduct could not only improve consumer confidence in advisors, but also reduce marketing costs for advisors trying to gain consumer trust. Because, in the end, helping consumers differentiate between advisor ‘peaches’ and ‘lemons’ can improve the public’s experience with financial advice and, at the same time, reduce marketing expenses for advisors, which in turn can reduce the total cost of advice and attract prospective clients from a broader pool willing and able to work with an advisor, as access to quality advice increases as well!
Welcome back to the 299th episode of the Financial Advisor Success Podcast!
Welcome back to the 298th episode of the Financial Advisor Success Podcast!
