Why It’s So Hard for Brokers to Act in Clients’ Best Interests

In “Freakonomics” (one of my favorite non-fiction books), University of Chicago economist Steven Levitt and Stephen Dubner explore the unexpected economic realities of diverse topics from the Ku Klux Klan to drug dealing to cheating school teachers. For the financial advisory world, Levitt’s most relevant chapter is about the economics of real estate brokerage.

As you’re undoubtedly aware, the vast majority of real estate agents are paid a commission based on a percentage of the purchase price of a house. That means the buyer is paying the commission, but it’s really coming out of the seller’s pocket. 

Now, most of us (me included) would think this financial arrangement is a good one for sellers, in that it puts the broker’s incentives in the right place: The broker makes more money if the house sells for more money. As for home buyers, who often have a broker of their own (who splits the commission with the selling brokers), this arrangement doesn’t look so good.

However, Professor Levitt tells us that both assessments are wrong. When he looked at data on actual selling prices for house sales involving brokers vs. sales without brokers, he found that, on average, sellers without real estate brokers sold their homes for more. 

How can this be? Levitt points us to the actual economics of real estate sales: While both brokers might pocket a bit more if a house were to sell for $10,000 or $20,000 more, those negotiations will take time. Time that the brokers could be selling another house—and essentially doubling their income.

It turns out that real estate sales is a volume business, not an advocacy business for either the seller or the buyer: Close the deal quickly, take the commission, move on to the next sale. Brokers who sell twice as many houses in a year at lower prices make substantially more those who “waste” time negotiating higher prices.

For me, the takeaway from this and the other examples in Levitt’s book is that the economics of a situation may be very different from how they first appear.

This seemed a helpful insight as I was trying to decide what to make of Janet Levaux’s May 20 story “On Wall Street, if You Earn More You Cheat More, Study Finds,” which I highly encourage every advisor to read. Her article is about a recent survey, conducted by the University of Notre Dame and the law firm Labaton Sucharow, LLP, of “1,025” brokers in the U.S. (925) and the U.K. (300). Here are a few highlights of their findings: 

• • “47% said their rivals [in other firms] have engaged in unethical or illegal activity to gain an edge.” 
  • “23% believe that their colleagues likely have engaged in illegal or unethical activity in order to gain an edge.”
    
  • “34% of those making $500,000 or more annually say they have actually witnessed or have first-hand knowledge of wrongdoing in the workplace…” 
  • “Nearly one in five professionals feels it is at least sometimes necessary to bend or break the rules to get ahead in the field… …[and] 32% say compensation structures or bonus plans pressure employees to compromise ethical standards or violate the law…” 

Now, human nature being what it is, and the fact that is an “opinion poll” rather than verified fact, we could probably adjust these figures along the following lines: The brokers likely overstated the “unethical or illegal” activity in rival firms, and understated the occurrence of similar activity at their firms.