The following is a story of second hand automobiles: There are two groups of automobiles owner. One group maintains their cars very well and their cars never break down. It is likely their cars will last for many years to come. Another group of owners did not take care of their cars, as a result their cars break down frequently and likely to continue breaking down in the near future.

The group of owners which owns the well maintained cars wanted to sell their cars at $20,000.

The group of owners which owns the poorly maintained cars wanted to sell their cars at $10,000.

The former is higher priced because their cars were better maintained than the other group.

However, externally both groups of cars looked identical.

In the showroom, potential buyers came to see these second hand cars. Assumed that the maximum price the buyers are willing to buy is $20,000.Assuming both groups of sellers consists of equal proportion, buyers would buy at price 50% * 10000 + 50% * 20000 = $15,000 assuming random selection (as both groups of cars are externally identical).

So what happen? The sellers of poor quality cars got a higher price than they asked for. On the other hand, the sellers of good quality cars either have to accept at a lower price of $15,000 or refuse to sell it.

 ---------- The end of the story ---------

In the above story, we see that those car owners who had poor quality cars was actually able to sell their cars at a higher price while owners who had good quality cars were penalized – either they cannot sell at the maximum price or had to be contended at a lower price. Since there was no incentive for sellers to maintain their cars well and that there was an apparent “incentive” NOT to maintain their cars, this resulted in the market flooded with poorly maintained second hand cars. The losers were the buyers.

The reason why this happened was because buyers did not have all the information to make their purchasing decisions. Lousy sellers were not obligated to disclose that their cars were poorly maintained, while sellers of the better cars were unable to demonstrate that their cars were more superior since externally all cars at the showroom were the same. Therefore, there is a need for government regulation so that the salesperson has a fiduciary duty to make the disclosure that not all cars at the showrooms are the same.

I must admit that the above story was taken from an economic book on government regulation which I just read this afternoon.

In Singapore, there appears to be no regulation to impose upon such fiduciary duty. Instead, we operate in a “buyer beware” environment. What is “buyer beware”? It means that it is the buyer’s ultimate responsibility to make the decision based on all the information that he or she can find – nevermind much of such information is not available anyway.

The information asymmetrical is a problem because sellers know certain information which the buyers do not. Sometime sellers deliberately withhold such information (such as the sellers of poorly maintained cars in the above example) but sometime it is because the nature of the good or service which the buyer seeks is too complex even though there is no deliberate concealment of material facts. For the buyer to understand these complex disclosures would require so much time that the opportunity cost would far exceed the price which the buyer is willing to pay. Thus, buyers face with the choice of either (1) avoidance (i.e. not to buy the good or service) or (2) trust the seller and proceed to purchase. However, avoidance is not an easy choice as the buyer must consider the potentially unknown large opportunity cost of avoidance. So what exactly is this opportunity cost of avoidance? This variable is unknown due to information asymmetric.

So far I have not given any real life examples in Singapore. So here are two real examples: Investment Products and Professional Financial services.

1. Investment products potentially can be really complex. Most of the material information of investment products are already thoroughly disclosed in prospectus (for investments) and benefit illustration (for insurance). Yet the nature of the product can be so complex to the extend that the buyer is not able to comprehend the given documents. For such a case, there is complete disclosure yet information is not asymmetric as the buyer cannot understand. That is why there is a widespread problem of investors being “burnt” and “cheated” for investing in unsuitable products.  
2. For the case of provider of professional financial services like myself, I have found the massive flood of advisers self-proclaiming to be “consultants,” “associates,” and “wealth managers” make it impossible for buyers of such services (i.e. prospecting clients) to make any distinction the skill of one adviser to another. Externally all advisers look the same. Some even carry high class brand names of their Principal. So how are prospecting clients going to make decisions? Worst still, many of these advisers claim to give “free” advice which we all know are far from truth. 

Using the same analogy as the automobile story above, the quality of investment products decreases. High quality products do not get the required attention since it cannot be distinguish from the rest. What we have is a flood of poor quality investment products in the market place.

For professional services, it too decreases in quality. Financial advisers who are incompetent get rewarded, while the more competent ones would either compromise in quality, be contended with lower pay than they should have or exit from the industry all altogether. Exiting from the industry is analogous as the automobile sellers refusing to sell.

So what is the solution? Introduce FIDUCIARY DUTY into REGULATION.

Hello, MAS you sleeping? Wakeup, sun has risen, you got job to do!