How Do Investors Discipline Financial Advisors' Activity

To Trust is Good, But to Control is Better: How Do Investors Discipline Financial Advisors’ Activity

Riccardo Calcagno

EMLYON Business School; Center for Research on Pensions and Welfare Policies (CeRP)

Maela Giofre

Department of Economics and Statistics “Cognetti de Martiis”; CeRP-CCA; Netspar

Maria Cesira Urzi Brancati

International Longevity Centre; CeRP

January 2, 2016


Using a survey of clients from one of the largest Italian banks, we investigate whether investors exert some form of control over the quality of the recommendations they receive, and if so which one. We find that investors with low level of trust seek financial counseling, but decide autonomously. Within this subgroup of investors, those with high self-assessed financial competence are more likely to control the quality of the advice. We also observe that their test-based degree of financial literacy affects the way they discipline the financial advisors. Investors with high financial literacy monitor the advisor’s activity by themselves. Instead, investors with low financial literacy are more likely to search for a second expert’s opinion which confirms the recommendations previously received, as for credence services. Our findings suggest that access to different financial institutions is beneficial especially for investors with poor financial literacy.

To Trust is Good, But to Control is Better: How Do Investors Discipline Financial Advisors’ Activity – Introduction

Investors are confronted with increasingly complex financial decisions, partly because shifting economic policies have forced them to take more responsibilities and partly because the menu of retail financial products has been growing steadily. This poses a serious challenge to investors who want to buy the best possible financial product given their lifetime needs. Several authors (Inderst and Ottaviani (2012a), Inderst and Ottaviani (2012c), Georgarakos and Inderst (2011)) argue that the optimal financial choice depends on investor specific need and personal characteristics. For example, the best real estate mortgage, the optimal pension scheme or investment plan depend respectively on the client expected income stream, desired level of well-being at retirement, risk attitude or tax bracket. In accordance to this view, Gennaioli et al. (2015) consider financial advice as a credence service similar to medicine, where “money doctors help investors to get the most appropriate treatment”.1 As for medical treatments, the accuracy of the expert in solving the client problem is not observable, the final success of the service is not contractible and the expert’s effort is costly, so that the investor-advisor relation is affected by moral hazard (Dulleck and Kerchmbamer (2006); Pesendorfer and Wolinsky (2003); Fong (2005)). Hence, investors who rely on professional financial advice either do so because they trust their financial advisors, as in Gennaioli et al. (2015), or because, despite anticipating the conflict of interest with the advisor, they are ready to control the quality of the recommendations they receive.

This paper studies whether investors exert some form of control over the quality of the recommendations they receive. If this is the case, we check how their degree of financial knowledge affects the control mechanism they enact.

To this purpose, we use the 2007 Unicredit Investors Survey (UCS) conducted on a sample of 1,676 individuals with a current account in one of the banks of the largest Italian banking group. We find that, irrespective of their level of financial education, investors with high trust in their financial advisors fully delegate them their financial decisions, as predicted by Gennaioli et al. (2015).

In our dataset a large fraction of investors who demand professional advice however do not delegate but take decisions autonomously after having received professional recommendations. These investors show a lower level of trust in the advisors than those who fully delegate their investment decisions. The main purpose of our paper is to investigate whether among these investors, those with higher financial literacy are more likely to exert some form of control over the advisor activity. Moreover, we try to assess whether their financial literacy affects the form of control they put in place. Pesendorfer and Wolinsky (2003) consider the search for second professional opinions as the most appropriate disciplining mechanism for standard credence goods, such as medical advice. Differently from medical counselling, financially educated investors when confronted with financial advice could try to verify the accuracy of the expert’s recommendation by themselves. The monitoring costs are probably lower for investors with higher financial competence.

We show that the self-assessed level of financial competence is strongly related to some form of control activity: investors more confident in their own financial knowledge are more likely to check the quality of financial advisors recommendations.

We also find strong evidence that investors with the highest level of test-based financial literacy exert a direct form of control on the advisor’s activity. Instead, investors with the lowest level of financial competence are more likely to compare the recommendations they have received with second opinions, as postulated by Pesendorfer and Wolinsky (2003) for standard credence services. These results are robust if we take into account the potential endogeneity of both the level of trust in the advisors and of the degree of financial literacy.

financial advisors

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