Brokers versus Retail Investors: Conflicting Interests and Dominated Products

Abstract

I study how brokers distort household investment decisions. Using a novel convertible bond data set, I find that consumers often purchase dominated bonds—cheap and expensive otherwise-identical bonds coexist in the market. Brokers are incentivized to sell the dominated bonds, typically earning two times greater fees for selling them. I develop and estimate a broker-intermediated search model that rationalizes this behavior. The estimates indicate that costly search is a key friction in financial markets, but the effects of search costs are compounded when brokers are incentivized to direct the search of consumers toward high-fee inferior products.