Does disclosure help? :: Business Line

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You visit a doctor to cure a certain ailment. The doctor prescribes some tests including a scan to diagnose the problem. You later realise that the doctor received referral fees from the scanning facility. You believe that the doctor was using you to generate business. Would it have helped if the doctor had disclosed the referral arrangement?

REFERRAL ARRANGEMENTS

Consider investment services where firms disclose referral arrangements. Suppose a sell-side firm gives a “buy” recommendation on a stock and also discloses that it holds shares in the company. How would you react to such disclosure? It would be natural to believe that the analyst would have overvalued the stock to make it look attractive. But how would you correct the valuation? Reduce it by 10 per cent?

Behavioural economists argue that we typically do not discount such information enough. An experiment in this area required the subjects to guess the number of coins in a jar with the help of a hired advisor. Some advisors were paid based on how high a number the subject estimated and this fact was disclosed to the subjects. It was clearly in the advisors' interest to recommend their clients a higher number. The subjects knew it. Yet, they discounted the advisors estimate by only half! Why?

The advisers inflated the number because they knew the subjects would discount it! But the subjects were unsure on how to use the disclosure of conflict of interest. And so did not discount the information enough. Extending the argument, would it help if your doctor discloses conflict of interest? My friend recently faced such a situation when his doctor admitted to having a referral arrangement with a diagnostic facility. And my friend reacted the way most people in similar situations do – he ignored the information!

Hence, it is better to avoid conflicts. Brokerage firms get around this problem by avoiding coverage on stocks in which they have exposure. And in cases where such conflicts cannot be avoided, it is moot if disclosure helps.