Dan Egan: Noisy Successes and Silent Failures

Our guest on the podcast today is Dan Egan. Egan is the director of behavioral finance and investing at Betterment, and he has researched behavioral finance topics extensively over his career. Prior to joining Betterment, he was a behavioral finance specialist for Barclays Wealth. He received his bachelor's degree in economics from Boston University and his Master of Science degree in decision science from the London School of Economics.

Background

Bio

Research

Frictions and 'Free'

"Closing the Behavior Gap," Betterment.com, Dec. 11, 2018.

"'Most People Don’t Want to Be Called Average,' Says Betterment's Dan Egan, Who Designs Financial Tools for Them Anyway," by Andrea Riquier, MarketWatch, June 16, 2020.

"How Checking Performance Might Hurt Your Performance," by Dan Egan, Betterment.com, May 20, 2019.

"The Myth of the Panicky Individual Investor," by Dan Egan, dpegan.com, March 14, 2020.

"Memestonks: What's Different About This Market," by Dan Egan, Betterment.com, Jan. 29, 2021.

"5 Red Flags to Look out for in Your Favorite Investing App," by Liz Knueven, Insider, Feb. 17, 2021.

"Low Cost Is Better Than Free," by Dan Egan, dpegan.com, March 23, 2021.

"Are Commission-Free Investing Apps Encouraging Reckless Behavior?" by Robert Farrington, Forbes, Dec. 3, 2019.

Betterment

"Using Investment Goals at Betterment," by Dan Egan, Betterment.com, July 27, 2021.

"How Much to Save: Our Advice Guides You Toward Your Goals," by Dan Egan, Betterment.com, Jan. 24, 2019.

“Betterment's 401(k) Investment Approach," by Dan Egan, Betterment.com, Feb. 2, 2021.

"Q&A: What's the Future of Investing?" Betterment.com, Feb. 17, 2021.

"When It Comes to ESG, Investors Want Specifics—and They Should," by Elizabeth Thompson, Spark Network, Feb. 4, 2021.

"'Robo' Advisers Betterment, Wealthfront Get in on Socially Responsible Investing," by Anne Tergesen, The Wall Street Journal, July 19, 2017.

Retirement

"Lifestyle Creep: The Biggest Threat to Financial Planning," by Dan Egan, Betterment.com, Feb. 28, 2019.

"Tiny Changes Can Help You Achieve Savings Goals for Retirement," by Anne Tergesen, The Wall Street Journal, Dec. 28, 2020.

Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance and retirement planning for Morningstar.

Jeff Ptak: And I'm Jeff Ptak, chief ratings officer for Morningstar Research Services.

Benz: Our guest on the podcast today is Dan Egan. Dan is director of behavioral finance and investing at Betterment, and he has researched behavioral finance topics extensively over his career. Prior to joining Betterment, he was a behavioral finance specialist for Barclays Wealth. He received his bachelor's in economics from Boston University and his Master of Science degree in decision science from the London School of Economics.

Dan, welcome to The Long View.

Dan Egan: Thank you for having me.

Benz: Well, thanks for being here. In your bio, you say a key goal in your job at Betterment is to help make good behavior automatic and bad behavior difficult. And you note that Betterment's customers have one of the lowest behavioral gaps of the digital platforms. Explain what a behavior gap is, as well as how Betterment has aimed to close it.

Egan: I think of a behavior gap as against some ideal benchmark, like an index fund might have an index, which is some platonic ideal that tracks. A behavior gap is a difference between, kind of like the outcome that could have occurred with less effort or less mistakes, had the person not been godlike and omniscient in their foresight and their behavior, but it could have been achieved with a lot less stress, much like you might achieve a pretty good return in an index fund. And so, the gap is a little bit the difference between outcomes of what people actually have when it comes to either their investment performance or their more overall financial performance of saving and spending and dealing with cash flows through their life.

In the case of the behavior gap research that you referenced, we were specifically looking at how well or not well people time changes to their allocation and their cash flows in their portfolio. So, do people outperform the market because of when they increase risk or decrease risk in their portfolio and when they add money and take money out? Or do they underperform it? And there are various different methodologies for this, spanning from the fund-level research that Morningstar does to individual account-level research that is very rare, because it's hard to get your hands on individual account-level stuff. And so, our study was at both an account level-- because Betterment clients can have more than one type of account and more of a type of goal and at the individual level. So rolling those up, looking at how people change allocations, put money in and took money out, and broadly looking at it and saying--because of when they time these things, were they better off or worse off than they would have been if they'd taken a lazy or more systematic approach?

And what we found was that there was a very, very, very slight small behavior gap--I think it was on the order of 0.35% per year--in how well people were doing compared with a very low effort, automate everything, don't put a lot of effort in strategy. And that compares pretty well with other studies, that depending upon how active the person is, what kind of investments they are able to access, you see ranges from about 60 to 85 basis points all the way up to 7%, which is a pretty wide range.

Benz: It seems like we're at a juncture right now that might entice people to make bad timing decisions. Would you say that's the case, first of all--do frothy market environments tend to encourage that sort of behavior? And how do you think about coaching people to not fall into that trap of performance-chasing that can often happen in environments like the current one?

Egan: I tend to think of it a little bit leniently. We're coming up on Thanksgiving, people are going to eat more, and they are going to eat more sweets and so on than they would otherwise. And simply saying, no, don't do that, being a little bit of a nag is probably the least effective way to handle it. And not only that, but it's a negative experience for the client. So, there are a couple of different ways that I tend to think about this, most of which are not centered around telling people no.

One is to try and make the focus and the attention on more virtuous activities, trying to make it fun and simple and easy to either pay attention to the goals that you're trying to achieve, and all the different levers that you have at your hands to achieve them, be it, how long you invest for, how much you save, whether or not you escalate your savings, and so on. All the things that are a positive, like when you come in and you see red in your account, that's a red that you could resolve to green because you have some control on the agency over the inputs that are causing that.

Another is giving them information at that point in time that probably should be included in their decision. So, if somebody is on track for retirement, but part of that on track means that they're still going to be investing for another 15, 20 years and accumulating a risk premium over that period, and they say, “Well, I would really like to go to cash right now.” The consequences of that are that for however long they are in cash, they are going to be earning a lower return, and that can send their plans off track. The same is true if they're making a withdrawal. And they might not realize that they're going to owe a large amount of short-term capital gains when they make that withdrawal, which means that the withdrawal is worth less than they might think it is.

So, those two things are point in time, the consumer is thinking of making a decision. And as somebody who's involved with the sorts of decisions day in and day out, you have a little bit of insight about the things that people might not be thinking about in terms of the consequences of their action that they should, that they should have as part of their decision framework and making them a little bit more available and salient at that point in time.

And then, the last is to give people a framework by which they can have fun, while still being responsible. So, it's not, “No, don't eat any ice cream ever.” It's, “Yes, of course--one day a week have a cheat day. And I want you to quarantine all of your vice inside that one day, and I want you to really enjoy it. I want you to look forward to it the other six days of the week. But I do want to time box or otherwise box it.” And that's where we tend to say to clients, “Listen, it is totally fine for you to have a gambling or speculative play pot. If you can get tremendous returns inside of there, that's wonderful, you'll be much better off for it. But we also want to quarantine any mistakes or damage that happens in there so that it does not mean that your kid isn't going to college.” Fun is great. But we also have the responsible side of things that we want to be taking care of to tick all the boxes.

Ptak: So, when you survey the landscape and consider some of the behaviors that we do see some, not all, but some investors engaging in crypto comes to mind, meme stocks. Another example where, on the one hand, you could say, “They're getting it out of their system, they're experimenting a bit, this is healthy.” On the other hand, you could look at it and be alarmed. And when you look at that, given your experience and perspective, what do you see?

Egan: So, the thing that concerns me most about it is the asymmetry of what you hear about a lot of the time. And that is, what I'm going to call noisy successes and silent failures. And it is very common to hear about how much a currency has gone up, how high it is, people who made an incredible amount of money on it. I think about the news and dog bites man, that's not news; man bites dog, that's unusual, that's salient, that's interesting and novel, that's news.

So, when we hear about the fundamentally unusual things in the news, the things that get a lot more press, that can lead us to having a really nonrepresentative view of what's actually going on. And it does lead to performance-chasing in the form of what you're going to hear about the thing that went up a ton. You're less likely to hear about a lot of the mistakes that might have happened along the way. And I use this mostly just because it's number one, a gut-wrenching, but also a very salient thing to me, of the young man who I think had a young family, did some margin trading on a brokerage app, didn't understand exactly what was going on with the way the numbers were displayed, and so on. Thought he had lost more than his life savings and his family was going to be in very bad shape and ended up taking his own life. I like the idea of things like this as ways for people to learn.

But you do not learn by making mistakes so large and extreme that you can't recover. Good learning and we know this, time and time again, we know what good pedagogy is. It's usually, like we're going to put you through a course of things where there are tight feedback loops that have high fidelity, where you are looking to understand and practice a very specific skill. I like the idea of onboarding new people to investing, to getting their feet wet in it. I don't think a lot of what's out there right now is effective as a learning tool, because in investing, the feedback loops are very noisy when you make an investment and it goes up--was it because you were a genius, or was it because you're lucky? Can you do it again? And they're also not necessarily sized well to give people the skill sets and the feedback loops, and the understandings of this is the amount of risk that I took on when I made this investment, this is what I learned in terms of how to invest in individual names versus ETFs versus mutual funds. So, I like the idea of it, but I think we do not yet have a setup where the providers of these services have a stake in their clients' success. They have a stake in their clients' activity, the amount of stuff they do. And I think that that's a really nice switch that I would love to see happen is providers saying, “It actually is our job to help new investors learn, become savvy and do it in a way that is effective and safe,” where after a short period of time you are comfortable saying, “You have all the knowledge and skill that you need to be able to go out and do the complicated stuff,” and that's not just throwing you to the sharks.

Benz: Speaking of learning and financial education, we've had some good debates on this podcast about what works in financial education--what works and what doesn't. So, what works in your point, and what types of educational interventions are well meaning but really unlikely to move the needle in terms of improving anyone's outcome?

Egan: I think there's a neat contrast here in that the design nudges that we use a lot of the time, I often liken them to, if you're writing a document in Word or Google Docs, or whatever it is, it's going to come with a font. There is no such thing as a document that doesn't start with some font. And it's just a question of what's going to be there. That's a lot of what the nudges and defaults and things are as things that you cannot escape them existing as part of the system, no matter what. You can be thoughtful and intentional about choosing which default you use. Financial education and literacy, I do think, are wonderful things. I'm one of those people who loves learning new things sometimes for the sake of them, probably to my detriment, where I've learned a lot of things that were not really useful in my life. But I think that like when and how you do it is very key for it being a positive force in someone's life.

So, sometimes it's easier to think about how to do it badly. If I wanted to design a bad financial curriculum, I would teach people things in a very mathematical and numeral way when it had no relevance to their life at that point in time. So, think about teaching high schoolers whether or not they should get a floating rate or fixed-rate mortgage--very important stuff, but not at that point in time. You want it to be when they are motivated to think about it, when they have some kind of a decision, and you want the education to be useful to making that decision. You don't want to be talking about geometric math when they're just trying to decide whether or not to take this credit card or that credit card.

I think that topical, just-in-time, targeted financial literacy and education when the person is motivated to make that decision can be very powerful and impactful. It's a really tough thing right now because the people who are most motivated and who have the circumstances to be able to deliver that education in that way, are usually the product providers of those services--who might not be as even handed as we would want in describing the pros and cons of different services. I sometimes think about it as, we have different drivers license levels. There's a normal car. There's a commercial drivers license. There's a motorcycle drivers license. It'd be nice to say, the more that somebody can take whatever kind of independent financial literacy courses there are, such that when it comes time for them to take out a mortgage, much as you might have like a FICO score, you could have like a literacy score, and someone says, “I know a lot about how mortgages work, I understand what's going on here. I've done that in some way. I am a better candidate for this than somebody who might have a lower financial literacy, please give me better terms.” And the dual reward there is that not only would consumers be able to understand it and be able to get those better terms, but there's also an incentive at that point in time for somebody to really have a high clearing house financial literacy score to be able to negotiate better terms on a mortgage.

So, I'm positive on it. But I also am very cynical about any top-down quasi-government mandated, do this while they're still in school so that we can tick a box, because I don't think those skills are relevant and temporal to the decisions that they're making at that point in time.

Ptak: Maybe in that vein, do you think that the financial-services industry in general puts too much of a focus on retirement? Especially for younger people, saving for retirement is important, but do you think that young people get more motivated by hitting short- and intermediate-term financial goals like home down payments or maybe taking a sabbatical from work, that sort of thing?

Egan: This is one that I feel very ambivalent about, which I like. I like feeling strongly in two directions about the same thing. So, the conventional line is going to be: when you're young, the dollar save that you put into your Roth IRA when you're like 19-years-old from a summer job--this is what my father basically told me to do back then. It's very powerful. It is the most valuable dollar that you can put in there because of the amount of time it has to grow. And I think that there's a lot to be said for having specific labeled account types like retirement accounts, like 401(k)s that are explicitly, these things are for retirement, you should put your money in them. We want to, as a society, encourage you to do that, because we've moved away from defined benefit or pension schemes and toward individuals being responsible for it. And I do think that it's going to be very hard for a lot of people to do a good job saving for retirement if they do it only in the last, I'm going to say, like 10, 15 years of their working life. They will have to save just in on the cash, the amount of money that they need, whereas the earlier you start saving for retirement, the less you actually have to save, because there's going to be growth that gets bundled up inside.

I do think, on the opposite end, exactly what you're saying is true, which is that for a lot of people, the motivation is going to be a near-term thing that they want to achieve. And I think this is tough when you say, let's go through some kind of an archetypal--this isn't any actual person, but it's like an archetype of person. They go to school, maybe they go to college, they graduate, they're going to start working in their 20s, and they might be paying down debt for, let's say, 5 to 10 years. And then they're going to start saving for the house down payment, which will be significant, and they do that, and then they've got a house and the mortgage. Then they--and this is a tricky one--they should start saving for the first four years of their child's life, when daycare costs are going to be surprisingly astronomical and could really throw a wrench in the career path if they haven't thought ahead about the impact that that's going to have.

Then maybe you have like, 10 years--unfortunately, private school gets involved, and you got another expense. Then you've got college. I was having a conversation with somebody about this catch-up contribution at 55. And why does like $1,000, why does that happen? And I was like, “Well, if you have kids, and they go to college, 55 is about when you're going to expect that you're going to stop paying for college in some way for them.” And so, you're going to be like, I have some extra money, maybe I should start putting that toward retirement.

So, I do think that there is a sequentialism there, like this is the normal ordinary steps of life that we have to deal with. Unfortunately, backloading all of the savings for retirement into the final 10 or 15 years of somebody's life makes it an incredibly difficult thing for them to achieve easily stress-free because even more, I think, forced risk-taking into those later years when you want to be able to decrease risk right when you retire to feel a little bit more in control and safe with those early years. So, I do think that the ideal way is a blend of them, and that we should always be contributing some amount and a little bit toward retirement to benefit from that, but getting people excited about what they can achieve in the near term.

I'll push out a little bit more on this because I think it's really important. We need to do better at helping people see these goals—we’re going to call them--before they realize they have them. I, like a lot of people, was blindsided by how much early childcare costs. And there was no reason for this. I had my kid, I think I was 35 years old when I had my child. And I had parents who had been through this and we knew people who had kids. And still, I could have saved up the amount that I really needed for childcare over the preceding years and not had to be put into other things. But somebody said, “By the way, you don't know it yet, but I don't want to tell you nine months before you need to start thinking about it that this is going to be a significant cost. Let me start telling you about the fact that you should be precautionarily saving for a kid before you have a kid. Let me tell you that you should be saving for a house down payment before you know you're ready for it.”

The longer in advance we can identify these things that people are probably, if they follow somewhat that archetype of life, they're going to want to have money for it. That allows them to actually end up saving less over their life and enjoying it more because the market will make up for--whatever investment it is--will make up more of that balance when they need it. So, however much we can help people, either by having dedicated account types, labels, whatever it is to say, “You're a normal human, you're probably going to have some of these things come up, let's start saving and planning for them before we realize we need money for it so that we're able to have a smoother, kind of like, more balanced life before that.”

Benz: To follow up on that idea of having dedicated accounts that aren't just retirement accounts but to other goals. Are you a supporter of that idea? And should that somehow work its way into our system do you think? Would that help encourage healthy mental accounting that could help people actually get some of these goals taken care of?

Egan: Absolutely. I think we overestimate how much of it is about taxes versus labeling. It's a very subtle finding, which is almost a throwaway because it wasn't the main point of the paper. One of the findings that you see over and over again is that people speculate and trade a lot in their taxable accounts. And that's a little bit silly. These are people who also have individual retirement accounts sitting next to them that are effectively a brokerage account. You can trade whatever you want inside of them. And critically, there are no capital gains taxes on anything you sell inside of them. And time and time again, you will see people saying, “Yeah, but that's my retirement money. It's a virtuous thing that I know is for serious purposes, and I'm not going to mess around with it.” And counterintuitively, so people will trade more in taxable accounts, realize capital gains taxes, even though they've got an IRA sitting right there, where their net take-home would be better if they've done the same thing inside that retirement account. Because it's labeled for retirement, they're not going to do that.

So, I think it's good to have a little bit of tax benefit, because it gives people a feeling like, “I need to put money in here in order to benefit from that.” I think we underestimate how powerful it is to simply have accounts that are labeled, this is what this is for--this is for retirement, this is my emergency savings fund, this is for my first house down payment. I worry about the complication of having all the proliferation of different account types and different names and so on. I think we've seen that already a little bit in this FSA versus HSA space, which does lead to confusion. But if it can be done simply and in a way that most people understand, I think it can be very powerful for saying I am saving for this purpose and it's a virtuous thing that I'm going to act a little bit more responsibly with, because of that.

Ptak: You've written that inexpensive maybe better than free when it comes to investing. In fact, you say, “free may be poison wrapped in chocolate.” I'm quoting you there. Why, in your opinion, are free trading services and say, free index funds, problematic in your opinion?

Egan: So, there are two reasons. One has to do with the way our brain works. And the other has to do with the second order consequences of how the person supplying the service gets paid. So, the first one, how your brain understands free.

Your brain, and I'm not saying this pejoratively, is a little bit lazy. It likes decisions and things that are easier than things that are hard. It's going to try and go for an easy option, because it doesn't have to think it through. And so, the classic study on this is, you're walking down the street and there's somebody who's selling chocolates, and they've got a really nice chocolate for like $0.15, say, some sort of Lindt truffle, and they've got a very inexpensive chocolate a Hershey's Kisses for $0.01. So, $0.14 difference between them. And you still say, “Well, you know what, a Lindt truffle for $0.15 isn't bad, I'll take one of those, yes, please,” and you pay your $0.15 and go on your way. Now, later that day, you're coming back in the opposite direction, and the kid who's selling them wants to get rid of all of his inventory, he's tired of this and has shifted the price down by $0.01. So, now, the Lindt are $0.14, and the Hershey's Kisses are now free. Whereas before, about 85% of people take the expensive chocolate, when the cheap chocolate is free, doesn't cost you anything, it flips, and all of a sudden, people start consuming the cheap chocolate.

And there's some good and bad reasons for this. The good reason is like, I don't even have to worry about money, I don't have to pay anything, it's simpler, I don't have to keep track of what card is this on, is it going to billed again, and so on. But it also means you don't think is this worth it? And there's lots of ways things might be worth it--there's your time, there's the space that it takes up, there's whether or not you even need the calories, or you simply say it's not worth a penny and also, I've already had enough chocolate. When things are free, because we don't engage the part of our brain that involves trade-offs, we don't say, “Is this value worth what I'm going to pay for it?” It kind of gets a pass. And so, we tend to overconsume things that are free. We consume them more than we would if we even had to pay an incredibly small amount for it, even a penny for a chocolate. So, free is categorically different to how your brain assesses things and that is a lazy overconsumption way.

On the flip side, with social media or brokerage apps, when you're not the person paying for the service, that service provider is going to be getting paid by somebody else. The standard quote, especially in tech circles, is “If you're not paying, you are not the customer; you are the product, you are the sheep being sold to somebody else.” What does that mean? How does that actually manifest itself?

So, I'm going to go through how this manifests very subtly from the inside, which is, say I'm a brokerage app. How do brokerage apps make money? Well, number one, obviously, by people trading. Whenever a trade is brokered between two people, there might be a spread, there might be a commission. But when that activity happens, that activity is how a brokerage is going to make money in one case. In another, if you hold cash, they will be able to make interest off of that cash, and they won't pay you for it. So, paying cash is pretty good. They will make more money in less-liquid securities, things like penny stocks or call options, than very liquid bonds. And so, if that's how they get paid, that's what they are going to optimize for. You have professionals whose entire job is to say, “How can we get somebody to trade more frequently in less-liquid securities, and potentially hold more cash?” That is our reward. And they're professionals, they control the design of the brokerage app, they control the push notifications, the messages you might get. That is what they're going to push for, and you're not going to pay for it visibly. You never get a bill that says the spread that we charged you on this transaction was 4% or 5%. But it's still there. You're constantly paying the toll as you go across the bridge; you just don't know that you're paying. So, the combination of these two things that your brain says, well, it's free, so I can consume a lot of it, and it's not going to cost me anything. And that the person supplying the service says, “What I have to do is, in the case of a lot of social media apps, get you to spend a lot of time and attention on the app so that I can show you more ads, sometimes in a more targeted fashion. Or in the case of brokerage apps, I want you to trade more regardless of whether or not that trading is successful for you.” It means that we end up overconsuming, doing too much of something in either case, and in both cases, the cost is hidden, because it's an opportunity cost of what else you could have done rather than something that you paid out of pocket.

Benz: In the past 18 months to two years--during this pandemic period--we've seen an influx of new investors into the market including more people of color, more young people, which we discussed, and many of them are using these free trading services like Robinhood as their on-ramp. So, is free a good thing possibly if it can help get more people started in investing?

Egan: I'm going to come back to the point about learning requires a framework and a feedback loop that helps with learning. I love the idea. But I don't think that the way any of these apps are set up now encourage that kind of learning, or even that kind of positive experience with financial markets. So, there's a great study that was done in Germany years ago, specifically with brokerage clients, where they said, we would like to improve the investing of our clients. We actually want to give them useful feedback about their success. And so, they started sending out, I believe, in some cases, monthly, in other cases, it was quarterly, almost professional-level portfolio manager performance reports. Here was your turnover, here were the trades that did well, here's the attribution that decreased the value of your portfolio, here are the trades you made that increased the value of your portfolio relative to the index. And what they found as they started giving these brokerage traders these feedback notes was that they reduced how much and how often they traded. They had more diversified portfolios, and they tended to trade in more liquid things. This is all great. This is exactly what you want to see is that it was a very good learning environment where people got high-fidelity feedback about what led to success and what did not lead to success. And because of those feedback loops, they improved their behavior and their output.

That's the sort of thing that I think we would need inside of brokerage apps in order to say this is a great on-ramp. Here's a setting in which you have a counterparty who has a stakeholder in your success, not in your activity, not in whether or not you do a lot of stuff, but in you doing those things well, and you making good decisions.

I think a tricky part of your question is, does it have to be free? And this is absolutely one of the most torturous going back-and-forth things here, in that, I think odds are good if we charge some almost de minimis amount per trade, like $0.05 per trade. We would see a lot of the positive effects of people kicking into thoughtful introspection about the trade and saying, “Is that worth it? How sure am I that this is a good idea? Do I really want to go through with it?” Without making investing inaccessible to people who would bring lower account balances. And I think that's the real tension is how do we say… Obviously, if a commission on a trade is $5, then you come in with $100, immediately you have a negative 5% return. And both rationally, and in terms of feeling like you should be doing this thing, you would back off. So, I do think that technology has made it where the cost of those things should be much smaller, it almost seems silly to say this trade is going to cost you $0.50, this trade is going to cost you like $0.30. But you'd be surprised how much just that sort of itty bitty teeny tiny thing--which has not a lot of economic cost to it but has enough mental stimulation to say are you sure you want to do this, is it worth it?--would be effective.

And I'm going to make an example here of something that I saw internally with our client base. As I mentioned before, one of the things that a lot of self-directed investors forget or don't realize in the first place--we did a study a little while ago and said, there was something like 15% to 20% of people had no idea that you'd owe short-term capital gains if you sold things in a brokerage account, and that they were higher than long-term capital gains. There were others who knew that but forgot it or didn't realize it. So, in Betterment, if you go to make an allocation change or a withdrawal--and we try very, very hard to avoid triggering long-term capital gains. And when you do sell, we use a lot-selection mechanism, which picks the lots, the shares with the least tax embedded inside them to sell. So, we're very aggressively trying to minimize tax, but we can't always do it. If you say, please sell all the shares that are in a gain and they're all short term, we put up a screen that says: This is the tax impact of making this change just so you know. It's not going to Betterment; there isn't a fee we're charging. Come next April the IRS will be aware of the fact that you sold this at gain and considering your tax rate. Here's roughly what we think it will do to your taxes at that point in time.

And what we saw was that when we showed that to people, if they had a significant tax embedded--I think if it was something like greater than $7--the odds that they would go through with that allocation change dropped to, I believe, less than 1 in 10. And people would cycle through it, they would make less-extreme allocation changes, they would wait until things were long-term rather than short-term capital gains. But there was this cost. And I'd say $7 in taxes, this might have been on a $20,000 or $30,000 allocation change. It was not that the percentage was huge. It was just like, “Oh, OK, I'm going to have to pay like $3 in taxes, maybe this isn't worth it, maybe I'll wait a little longer.” So, very, very small costs can have an influence over consumer behavior in a way that's surprising.

Ptak: What about on the spending side of the ledger? Frictions have been removed there as well with innovations like Apple Pay and the disappearance of cash from many transactions. Does that make it harder for people to stick to budgets?

Egan: So, I'm going to say no, but I do think that's contingent upon an intentional decision about how you budget. I think now it is easier than ever in order to set up and stick to a budget. But you're right, it is easier to spend money. And the specific reason for that, which I'm sure, you'd understand, if I run out of cash, I can't spend it. There's no there's no credit in my pocket. So, replicating that experience of spending down to zero and being very aware of the fact that you're going down to zero is the key thing. And I call this top-down budgeting. Nick Holeman, our CFP, calls it pay-yourself-first budgeting, which is effectively, you get paid, you have your big nonnegotiable expenses--rent or mortgage, utilities, and so on--and then you also have your savings. And that stuff just flows right out so that when you're looking at your bank account, all you have is your spendable money. And each month, each pay period, whatever it is, you spend yourself down to zero. And I'm at the point where I can get push notifications every morning, or even after every transaction saying, “Hey, Dan, here you have $200 left to spend in the three days before you get paid.” So, go ahead, but that's the cash equivalent saying, “You can spend to zero and no further.”

I think the other side of this that's a little bit trickier is less about pure budgeting in terms of managing your cash flow and spending and is more about how easy it is to get various kinds of credit. And that makes it easy to spend more without really feeling a lot of pain over a short period of time than you would have otherwise. And right now, we happen to be in a period of relatively low interest rates. It hasn't percolated through into the credit cards, but I think it has percolated through into other spaces--the buy now pay later, and so on. So, it's not like in the magnitude harmful yet but it could be in the future where we develop the habit of, “Yes, I will buy this now and I will have some financing fee that could be pretty high just for the sake of being able to consume it sooner.” But I think, in general, the ability to set up the feedback loops of this is how much money you have to spend, how can you automate the savings so that you save, or you put money into the more virtuous things before you even get a chance to spend it, I think that's been easier than ever because of digital tools. It's just a question of you intentionally setting that up to work at the beginning of month rather than trying through willpower and self-control you have money leftover at the end of the month that you then put away.

Benz: Speaking of some of those household capital allocation choices, how does Betterment aim to help investors consider their total choice set? I would imagine that there might be some people who would come to Betterment and their best return on investment might be to pay down debt or invest in a 401(k) rather than giving the money to Betterment. So, how does Betterment provide feedback on those sorts of household capital allocation decisions?

Egan: The answer is that it's firewalled in that right now we do not. We can help you to decide where and how to save. So, if you come in and you say, “I'm thinking about saving for retirement across my and my wife's accounts. We both have 401(k)s, we both have IRAs, and so on, where and how should I save that in order to maximize that?” We can help you with that. We cannot--and this is firewalled within the client agreements we have and so on--we can't give you advice individually on where and when you should pay down debt given the various types of debt--forgivable versus non-forgivable student loan debt, and so on. We do have, I think, articles that go into how to make that decision for the person, the consideration of interest rates, can a debt be paused, is it good debt or bad debt, is it asset backed, and so on. While we as an industry have done a pretty good job at figuring out how to charge on assets under management, to my mind, all of the models that are based on charging for either liabilities under management or the specific and independent advice around those things, has not blown up. And I think what a lot of people would benefit from that doesn't exist yet, is the ability to get that kind of household across debts and balances advice in a way that wasn't directly attached to just asset management, to just the asset side of the balance sheet.

Ptak: We're going to shift gears a bit and ask you about direct indexing. Betterment doesn't seem to be in that space just yet. I could be wrong. But it's been rumored to be on the horizon for the firm. So, what do you view as the major pros and cons of direct indexing?

Egan: I think I follow along with a lot of what other people have said here. And the way I think about it is that it is a great solution if you have a very specific kind of problem. If you're somebody who's like, “I just want to invest in a kind of diversified portfolio, no strong opinions about anything, inside my Roth IRA.” There's not much benefit to it, and there's definitely cost and headache associated with it. The use cases for it are usually unusual, or they have been unusual historically, in that, maybe you're an executive with a concentrated position from your own company stock. Or maybe you worked with some sort of investing stock newsletter person, and you've ended up somehow with 15 really weird, concentrated positions over the years that have embedded tax in them and you don't want to liquidate it, but you also want to get diversified now. Or, and more recently, you have ethical or moral views that you want to adhere to, and those are specific to you. Those values might not be well implemented by using a series of funds. Even if those funds have some level of overlapping intention, they're not going to exactly nail the way that you think about things.

So, I think direct indexing, both if the transaction costs, which can be substantial or manageable, if the cost for managing the portfolio isn't excessive, and where you have a need for the kind of outcomes that it is able to handle, it can be very, very useful. I'm going to say, for most Americans, most people, who are doing this inside of a 401(k) or an IRA, where tax really isn't a consideration and where there are funds, which can, not perfectly, but get you 80% to 90% of the way there of expressing your views, there's not a tremendous amount of upside.

Benz: It seems like one of the main use cases you hear cited in the context of direct indexing is ESG, so for people who want ESG-type portfolios that they might be able to self-select their investments based on what their preferences are there. I'd like your take on that. And also, as a behavioral expert, have you seen any indications that ESG investors are more likely to stick with their plan because their belief system is aligned with their investments?

Egan: On the first question of does direct indexing allow, what I'm going to call, a much more finely detailed control over what you're investing in, yes, definitely. I think it's also a lot of work. I think it's easy to underestimate when you buy a fund that is going to follow some ESG criteria, how much work you have outsourced and that you've kind of taken the overhead costs and then you split it up amongst many, many, many, many, different people and shareholders and in a way where it's very explicit to the management of the companies what's going on there.

One of the things I think about is, if a company knows that it is approaching--and I'm not sure exactly what the thresholds are, 5% 10%--ownership of their company by an ESG fund, they're going to know, “OK, more and more, I need to listen and think about the consequences and the perceptions of people who are holding that fund when I'm making decisions for this company.” When that's done at an individual-shareholder level, there's less of an ability to communicate forcefully and clearly en masse what's going on there. There's very little ability for an individual shareholder to say, “Listen company, you've got a couple of decisions coming up that are going to drive whether or not I continue to invest in your company. It sure would be good if you lean this way rather than that way.”

I think that there are hidden benefits to funds in the scale and scope and ability to be done professionally, both in terms of communication channels, but also in terms of the ongoing monitoring of exactly how and why decisions are being made inside of the companies that can be underestimated. So, you need to have a very strong view about exactly how you wanted companies selected in order to manage a direct indexing ESG portfolio on an ongoing basis that effectively.

On the flip side, the second question that you asked, are SRI ESG investors generally better behaved? Everything I have seen points to the idea that yes, especially if that is because of an alignment between values and portfolios. So, if you believe in some sort of SRI or ESG because you just think it's going to have higher returns, well, then you're just basically performance-chasing like everybody else. That's not going to give you any kind of--to use the terminology of the kids these days--that's not going to give you diamond hands; you're still just going to have paper hands. And if things don't do well, you're probably still going to fold.

On the other hand, if you are able to look at your portfolio, and you're like, “This portfolio makes me proud, and it's aligned with who I am and how I think about things. It reflects my values as a person, I am investing in this thing for reasons other than just returns. I'm investing in this thing because this is the world that I want to see in my future, and I'm happy with it.” They are much more able to stick through drawdowns, they tend to save more consistently, less influenced by market events, and so on. So, yes, I think that when any kind of values-based portfolio allows somebody to say they are investing in it for more than just their own personal gains and returns, it will lead to better investor behavior.

Ptak: I wanted to shift and talk about retirement again. One behavioral issue that crops up in retirement is that many people have trouble transitioning from spending to saving. How does Betterment aim to help people approaching retirement figure out how much they can safely spend?

Egan: Each individual only retires themselves once. But an advisor gets to see lots of people go through this life cycle over and over again and sees this problem crop up time and time again. I actually think there's a component of it that starts with the individual investor in--I think what you're referring to, the way I'm going to detail it out is that--through the course of your investing life, you, number one, are earning money, you're going to a job 40 hours a week, you've got all the social structure that goes along with that, the consistent income to cover your needs, and a little bit extra that you're putting away into your 401(k), IRA, wherever it is. And while markets might go up and down because you're saving, you are seeing your score go up consistently. Each year, it's more than last year. It's able to go up and down really consistently. Over time, that balance gets to be large relative to the amount of income that you're bringing in. So, you're attention about, well, what's the valuable thing? Is it going to be the $15,000 I'm able to save this year? Or is it the $150,000 portfolio that I see sitting right over there that seems a lot bigger?

As your portfolio balance grows, those market gyrations feel a lot more real. The 15% drawdown on $1 million portfolio is a lot more substantial than a 15% drawdown on a $10,000 portfolio. The crux move--the crux is like the hardest move when you're going up a rock-climbing wall that kind of defines the entire realm--the crux move is, “OK, I have spent years earning money, having my needs covered, social structure and having my balance go up. And I retire, and all of a sudden, I have a lot more free time, all of the market’s gyrations seem directly tied to how much I'm going to be able to take out next year, and so on.” And so, my anxiety goes up. The concern that I have about the portfolio goes up. And even though I might know this conceptually, it is very hard to say, “My job is to make that balance go down. My score needs to be going down consistently in a very good pattern so that I can enjoy the next 20 years or however long it is.”

There are a number of designer behavioral hacks to deal with this. One is to try in as much as possible to frame everything throughout the entire lifecycle in annual income. Think about annuitizing and saying, “Right now, you are on track for $3,000 a month in real terms.” And that constantly being the bogy and what shifts up and down depending on savings rate in the market is, “Oh, no, the market went down, now you're on track for $2,800 per month in retirement.” So, having that always be the unit of account that we're talking about in retirement greatly helps you say like, “Well, now I'm retired, so I'm still on track for $2,800 or $3,200,” whatever it is.

The other is the very commonly used bucket strategy, which is used to segment retirement wealth into time horizon or needs-based buckets, where you say, “I am going to, no matter what, I'm going to have the next two to three years' worth of my needs in cash, so that I am always sleeping well at night, I'm never worried about that. Then I'm going to have another intermediate-term bucket, which is say, the three- to 10-year bucket that is going to be a little bit riskier but probably still bond heavy. And I'm OK taking a little bit out of that. And then, I'm going to finally have my long-term bucket--this is my longevity risk, or my ‘I hope it outperforms the portfolio that's going to be run this year.’” And that's mostly just a mental accounting thing that people are comfortable with the fact that, on average, that portfolio is going to turn out to be 50%, 60% stocks if you look at it holistically, but they're able to focus on the next two years being safe and comfortable in the cash component.

I think those are the well-known ways of trying to get people to nail the dismount of employed life well so that they get comfortable. I'm not a licensed CFP who has dealt with this live fire with a lot of clients. But those are the ones that I've heard, and that really resonate with me from a psychological point of view.

Benz: I wanted to talk about some of the retirement research that points to the value of non-portfolio income sources in retirement. There's been some studies that have pointed to the fact that people tend to take greater pleasure in spending from Social Security money or if they have an annuity. What's your take on that research? And how does that fit into the in-retirement guidance that Betterment provides to people?

Egan: I think one of the ways that Betterment tends to try and nudge clients to do better financially is to give their money purpose, to say these are the goals, and it can be whatever. We have a lot of Tesla goals, for example. And one of the things that does, in line with what you're talking about, is it makes people feel guiltless when they withdraw the money for the goals, like an achievement. I set myself a target, I have achieved it and I'm going to feel good about pulling the money out of it.

What's tricky about it is whether or not we can reframe how they're spending in a way that is better for them, which is very, very, very, very tricky. If we could have people feel guiltless and effective at spending money in a good way--there's a lot of research that people who actually enjoy being conservative and safe, and they can actually feel guilty spending money and they end up having a lot of stress about even spending money on the things that they knew that they were going to spend money on and that they've saved and they're perfectly fine for it, versus people who are a little bit too profligate. They spend money too easily.

Benz: Has Betterment experimented with a fee-for-service model, for example, offering advice on an hourly or a per-job basis, per-task basis? The assets under management model makes paying simpler and less painful in a lot of ways. But the other models, where the client writes a check for the amount of advisor time he or she used, that kind of seems more fair. So, can you address how Betterment is approaching that and thinking about that set of issues?

Egan: Absolutely. We have done a lot of trying out things here. So, years ago, under the then head of advice, Alex Benke, we implemented what we call “advice packages,” and these are available to anyone. You do not have to have a single dollar with Betterment in order to use them. You can call us up out of the blue. And they tend to be very topic based. So, it'd be like, “I want to spend two hours going through planning for my kids' college education or deciding about a house down payment.” And over the years, we refined what those topics are and exactly how much prep time a CFP would need in order to get all the information from the client and deliver it to them. But they generally range from, I think, about $100 up to $400, and again, generally for somewhere between one hour to four hours' worth of a CFP's time. And they're completely that--you pay for them online just like you would a TV.

And they've been very, very useful for people who have exactly that kind of need. In fact, Betterment has a what we call Betterment Premium Offering that is an asset-based fee. And what we were seeing is that there were people who said, “Well, really what I want is I want some initial help with getting my accounts set up correctly so that I'm established, and then I should be able to manage it on an ongoing basis.” And we specifically have a premium call, which is like getting set up correctly, which involves just going in and saying, “Let's make sure that the beneficiaries are done correctly, the allocations are set, the goals and targets are set,” and then it runs itself. So, not only has allowing for those a la carte, topical or short-term advice-based relationships done well on their own, they've also done well for the digital-advice experience, because we know that more clients are going to spend a little bit of money but get set up in a really high-fidelity way, and then the technology takes it from there and is able to run things.

Benz: Well, Dan, this has been such a fascinating conversation. We really appreciate you taking time out of your schedule to be with us today.

Egan: My pleasure. Thank you.

Ptak: Thanks so much.

Benz: Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.

You can follow us on Twitter @Christine_Benz.

Ptak: And @Syouth1, which is, S-Y-O-U-T-H and the number 1.

Benz: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)