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  • Bogleheads on Investing with Dan Egan – Episode 6

Bogleheads on Investing with Dan Egan – Episode 6

Post on: February 6, 2019 by Rick Ferri

Dan Egan is our guest in Episode 6. Mr. Daniel P. Egan is the Director of Behavioral Finance and Investing at Betterment and an up-and-coming leader in the field of improving personal decision making by understanding how psychology interacts with design, money, investing and spending. His research is reshaping how people interact with technology to make themselves better money managers.

Dan holds an MSc in Decision Science from London School of Economics and a BA (Distinction) in Economics from Boston University.

This podcast is hosted by Rick Ferri, and is sponsored by the John C. Bogle Center for Financial Literacy.

You can discuss this podcast in the Bogleheads forum here.

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Rick Ferri: My name is Rick Ferri and I’m the host of Bogleheads on Investing. This episode is brought to you by the John C. Bogle Center for Financial Literacy, a 501(c)(3) corporation.

Today we’re talking with Dan Egan. Dan is a behavioral scientist who works at Betterment. Betterment is a Robo-advisor who is using technology to help people invest better. And a lot of what Betterment is doing, and the programs that they’re running, are based on behavioral science. I’ve been following Dan’s work for several years now and I find it extremely interesting how this company is, for lack of a better word, controlling  their clients behavior by analyzing client data and testing various hypotheses in a real lab of hundreds of thousands of clients to improve their investment performance.

Let’s get right to Dan Egan. Welcome Dan.

Dan Egan: Thank you very much for having me.

Rick Ferri: I really appreciate you being on the show. You’re an up-and-comer if you will. What you’re doing at Betterment as the director of behavior science and investing is extremely interesting and I thought it’d be great to have you on the show so you can talk with us about all the work that you’re doing there, and all the neat stuff. It’s like you’re in this big lab in real world, and you get to actually run experiments on real people and do real things, as opposed to the theory sort of an ivory tower classroom setting. So can you tell us a little bit  about who you are and how you ended up at Betterment.

Dan Egan: It’s a great place to be but with great power comes great responsibility. I’ll trace out what I think is actually useful for the path that I got here by is interesting. It explains my background a bit. I did my graduate degree in decision science, which is a combination of psychology and game theory and statistics, so trying to figure out how to help people, real people, make better decisions. And I had never had any desire to go into finance or investing but during that program one of the people who I worked with said why don’t you come and work with my investment company for a little while. I thought, you know, I heard that these people get paid well and it sounds really interesting, what they’re doing, so I went and did that and I worked there for about a year. And it was an incredible experience, learning very quickly the difference between academic finance and real-world finance. And after doing that for a year I realized that that specific kind of finance, a private equity firm, was not what I wanted to do.

And this job came up at Barclays Wealth in the UK which is a high net worth asset management firm doing applied behavioral finance trying to help advisors give better advice, not only in terms of it fitting to the client better but also the client being more likely to adhere to it, to actually go through with it. And I worked there for about six years with advisors, both building behavioural tweaks of the platforms, as well as integrating it into their advice. And one of the things that kept striking me, as you’ve alluded to, is that there’s this three body problem going on. So we have the end investor, who’s going to come with their specific circumstances, but also their psyche and their particular strengths and weaknesses as an individual; then you have the same thing for the advisor; and here’s me sort of in the background trying to change the system, trying to change the system and the advisors and coach them and train them to see if we can help the end client be better off. And that’s a very noisy environment to be in, and the feedback is delayed and noisy. You’re never really sure if what you are doing is actually working.

So I moved to the US and I started looking at Betterment. It struck me as a great opportunity to improve upon a few of these things. So number one, I as a behavioral scientist can try to improve things with clients but test it in a rigorous fashion in the real world, see what  impact it has on the behavior and if it works, roll it out to all of them and have high confidence that it actually works, rather than hope that it works.

Rick Ferri: So what you were looking at Betterment as an option and you liked the idea that it was a real time experiment with real investors and at the time the company was up and running and they were using index funds. Had you given any thought to why John Stein had chosen index funds, and why that was the focus of the investment philosophy behind Betterment.

Dan Egan: I think there are a lot of reasons to go with index funds. Obviously they tend to be much lower cost than more opaque or more actively managed funds.They’re also more transparent about exactly what they’re going to do and when and how. They scale very well and that they can generally, you can put a lot of money into them and it’s not going to negatively affect the performance of the fund, which isn’t true of some active funds. And we want it to be able to say to clients that we were doing, what there was a lot of good long-run evidence for, which is that lower cost systematic index-based investing tends to do better. 

Rick Ferri: But you’re using only ETFs as opposed to open-end traditional mutual funds. Is that an operational reason or do you think they’re better than open-end funds.

Dan Egan: Kind of want to go with one type of fund. I would definitely say an ETF is better. We manage a lot of taxable accounts and ETFs are significantly more tax efficient than mutual funds. They are able to trade throughout the course of the day. That’s something that we can talk about and come back to you about whether or not that’s good or bad. If you use them in a portfolio provides some services and functions that it’s much harder to do with mutual funds. A very small example in terms of transparency is that a lot of mutual funds have 12b-1 and marketing fees embedded in them, which are not transparent to the end-user but is a way that third parties can be compensated for using those funds. Structurally that’s just not possible with ETFs. The ETF doesn’t know who owns it so there’s a level of transparency and an inability to have conflicts of interest that make ETFs preferable, as well as tax efficient.

Rick Ferri: The founder of the company, John Stein, made a comment that there would be no Betterment without Bogle. In fact I think that was the title of the article that he wrote and that Bogle was his idol and he was invited by Jack Bogle to go to Vanguard and he spent all day with Jack, and Jack was very encouraged by what he was doing.

And I can understand that because to get young people particularly interested in index fund investing at a young age is something that well, I didn’t have when I was growing up. You know when I was in my 20s there was one index fund but unfortunately I didn’t know about it so what you’re doing by getting the word out about index fund investing at a young age I find it to be very encouraging and very good for society long term.

Dan Egan: John hopes to do for broader personal finance what Jack Bogle did for investing. Jack was able to do well by doing good, he didn’t compromise on his morals, and what he thought was right. And his ability to be successful, to grow a very large company that’s served millions of people that’s a perfect inspiration for what we’re trying to do at Betterment. And I think that he created a little beachhead there in terms of investing and having low-cost funds that were owned as mutuals but that is a very small component of what most people need in terms of help with their finances. They need the ability to kind of plan for and manage cash flow better, the ability to use the correct account types, if we’re talking about a Roth or a traditional IRA or a 529.  Investing in personal finance is very complicated, especially if you want to do it, if you want to make the most out of all the possibilities out there. Making it easy for the vast majority of normal people to do that is John’s mission. 

Rick Ferri: One of the things that I found fascinating about Betterment is your automation. You truly believe that through automation you can get people to behave better and you talk a lot about bad behavior of investors and the cost of what’s called the behavior gap or the investor gap and there’s different names for it but you use the behavior gap. Can you first talk about the behavior gap and then talk about what Betterment is doing in the automation that you’ve created to get people to invest better? 

Dan Egan: Absolutely. So the behavior gap most broadly is that we might know what it is that we are supposed to do in order to get some kind of an optimal outcome but it’s hard for us to actually execute on it. You can think about wanting to lose weight, it’s fairly straightforward that you eat less and exercise more and you’ll probably lose weight, but it’s hard to actually get through with, to actually stay the course and be consistent in it. In investing we see this come up in a number of different places.

I think there’s a lot of the studies transparently lead to investors try and do too much and do the wrong things at the wrong time. They trade more than they should and every time they trade they probably pay commissions and bid-ask spreads and possibly even taxes if they have any gains that they realize. And they hold much more concentrated portfolios so they’ll hold a few stocks of companies that they’re familiar with or maybe they’ve done a little bit of research on, but they tend to not be very diversified, or not intentionally diversified. And these two or three things which actually take a lot of work and thought on the part of the investor end up with them underperforming a simple low cost index portfolio.

So there’s a strange thing where they’re doing worse because they’re putting a lot more effort in because they’re, they’re trying harder. What we’re trying to do is number one, make it so that people are confident and comfortable that they are doing the right thing by investing in the diversified portfolio, by allowing us to manage it in a really transparent systematic way for them, and that will help them be comfortable and reduce the kind of anxiety provoked actions they might take like selling out after the market goes down, or trading a little bit too much every month.

Rick Ferri: Now the interesting thing about your research is you have actual data. I mean you have access to literally hundreds of thousands of accounts that you can drill down into and you’d like to study quant and you’re a programmer and you can drill down into actual accounts whereas other researchers and academics, they would have to ask companies for data. You have the data and you can drill down and you can look at what your investors are doing and you found that even in your own accounts that there are behavioral issues even with your own investors.

Dan Egan: Based on our research about 70% of our clients are what I would consider like they get a 100 out of 100. The remaining 30% have very specific markers of when and why they behave badly. And I’d actually take your statement and double down on and say not only do I have access to really good data I really care about improving that data. If I could put myself out of a job that would be fantastic because when you look at that thirty percent of clients who are making specific mistakes it’s fairly predictable they are going to trade too much.  

One of the things that we look at is the role that gender plays and men trade, they log in more, they trade more than women and here’s the neat thing, when they trade they make much more extreme moves. So men are much more likely to go from a hundred percent stocks to zero percent stocks when these sort of whipsaws, whereas women are much more likely to go from 90 percent stocks down to 80 percent stocks if they’re going to make an allocation change. So looking at the things that predict people’s bad investing behavior, and then at the same time saying okay, how could I improve that? How do I reduce this gap using this behavior then going out and running scientific trials of those improvements, that’s what I love doing.

Rick Ferri: And so what have you found and what have you done to help that 30 percent who are making the mistakes.

Dan Egan: One component of it which is neat is knowing who’s really paying attention to the markets. If you take a hundred people and the market is going down and it’s generating a lot of news a standard traditional financial advisor, especially because of the client base they work with, might be tempted to say well, I need to get in touch with all my clients and tell them what I think about what’s going on in markets right now. And what we found, again running randomized control trials, is that the vast majority of people really aren’t paying that much attention to what’s going on in markets. They have other things in their lives that are far more important, and so if you do send out a sort of blast communication or email of some kind you’re actually going to generate more anxiety than you are going to resolve because you’re hitting a lot of people who weren’t worried about it.

Rick Ferri: Dan I completely agree with you when you talk about alerting clients that the market is going down so not to worry that that causes anxiety. I recall several times in my career when we were having a downturn in the market and some of the advisors who worked with me would say we need to send out a letter to clients to tell them everything’s okay and I would say no we don’t. If it’s not okay they’ll call us. If it is okay then let’s not make them worry because anytime we send out a letter that says don’t worry, they worry. 

Dan Egan: So one of the things that we, when we saw this issue, we said, “Okay so what we need to do, you know, much like as if you’re a doctor, is that you don’t treat everybody for disease, you only treat the people who are afflicted by it”. So we want to be able to identify just the people who are really engaged with markets, who are most likely to be anxious about what’s going on in markets, and so rather than sending out blast emails, when you log in we would send you a targeted notification with different messages to try and see if different messages resonate differently with different kinds of people. Some of the messages will be highly factual and relate to the market. Other messages will be very personal, they’ll say you’re doing a great job and you’re still on track for retirement, keep going. They’ll be positive and affirming of things. 

And in testing those messages we found that number one, the targeting rather than the shotgun blast is much, much more effective. It means that we get much fewer false positives; and number two, tailoring the message so that it is more relevant to how the person thinks about it and that it’s going to be more positive and affirming for them personally, is much more effective. Generally speaking when we run experiments to learn this we see the people who get those messages have about a fifteen to twenty percent improvement in their behavior, meaning that they’re less likely to make allocation changes or withdraw all their money.

Rick Ferri: Do you happen to go as far as sending a different message to men than you do to women, or different age groups?

Dan Egan: We haven’t intentionally targeted it quite that way yet. One of the reasons is that generally we use broad archetypal variables like age and gender because we don’t have a better measure of some underlying thing like how engaged you are with markets. If I can use a variable like the client’s login rate, how often they login, how often they login on mobile versus how long they log in on the web, that’s generally like a higher fidelity signal about how engaged they are with markets. Whereas a lot of other researchers will say, well young men tend to be the most engaged with markets. I would even go down to an individual level metric that lets me see what does this person look like they’re doing.

Rick Ferri: Though you wrote a paper called The Meerkat Effect where you found that on both positive and negative market days, big days, big up days, big down days, more people do have a tendency to log in and look at their accounts. But once they do log in you’re trying to ensure that they don’t do something about it.

Dan Egan: Yeah. This is an interesting thing that I think it’s worth taking a step back on to give better context to. One of the things I’ve learned over the years is that the same person will look and think fundamentally differently depending upon what platform they are on. Take a person who has a 401k through their employer.They are going to treat that 401k in terms of trading and logons and management very differently then they’re going to treat their Betterment account, which is very different than they’re going to treat their online brokerage playing account. The Meerkat Effect study was done on an online discount brokerage where a lot of people had highly concentrated portfolios and logged in to trade, and I think that behavior might be localized a bit to the platform that you’re on. You don’t go to Vegas to have a quiet time, and I think that the behavior that we’re going to see depending upon the data set, the same person who has a brokerage account is going to act differently inside that brokerage account than they’re going to act on the Betterment platform. 

Us and Vanguard have done studies looking at our clients looking at the same, when do people pay attention to their accounts in some markets? And you see we’re a little bit closer to Vanguard. And that when people have some inkling that the market is down and they’re going to be unhappy about their accounts they’re less likely to login. 

Rick Ferri: Dan, I found it was interesting in listening to one of your presentations that the 30 percent of the people who will get on the Betterment website and trade, that if you show them how much they’re going to have to pay in taxes if they do this trade that they’re thinking about that, it almost stops them in their tracks from doing the trade. Can you talk about how taxes, or the prospect of having to pay taxes affect people’s decisions. 

Dan Egan: Definitely, and I’m going to again take a step back and you have a little bit of broader context about why this is so interesting for end consumers. Most of us will have interacted with our finances through websites that are set up by brokers. And brokers, if you think about it, they have very specific incentives. They make money when you transact, when you trade or you buy and sell a fund, and they also make money when you hold cash. And that means that a lot of the interfaces we’re used to, in a very subtle way, encourage those two things: they’re going to encourage us to trade and they’re going to encourage us to hold cash. It might be by using red and green to indicate things going up and down, which excites us emotionally. Cash always feels safe. Here’s a neat thing, if you want to get rid of red on your holdings you can sell it and it just simply goes away. It’s like you never had that loss and you go back to feeling like you’re safe in cash.

And one of the things that’s different about Betterment is that we are a fiduciary advisor and we make money when clients grow their money more. So we’re kind of aligned in that way. So we don’t have these incentives to have people trade more or hold cash, and one of the things that we were noticing is that people were trading and look like they weren’t taking into account the fact that they were going to owe tax because they were realizing capital gains. And taxes work like a really really bad credit card, in that in February if you get worried about the markets and you sell out of everything and you realize a $1,000 short term capital gain, nobody tells you about it and you don’t owe any money right then. You have to wait until the following April when you do your taxes with the IRS to find out that actually you didn’t make a $1,000 gain, you made a $500 gain because the IRS is going to keep half of it.

So it was important to us to say well you know we don’t make money when people trade and maybe people are trading because they’re not taking into consideration all of the important factors, like how much this is going to be worth after they pay the taxes on it. So we were able to in real time, they say like I would like to go from 90% stocks to zero stocks where we calculate how much that’s going to realize in short-term and long-term capital gains and put up an estimate of that impact in front of them. And what we saw is that people who are given that information, if they were going to owe more than 50 dollars in taxes regardless of how big their account was, there was less than a 1 in 10 chance of them going through with the allocation change.

So the first component of it which I think is important is that it looks like people didn’t know or weren’t considering that when they do this thing now they’re going to owe a lot of tax because of the transaction. And simply by putting important information in front of them at that point in time we were able to reduce how much they were market timing.

Rick Ferri: You said if they were going to pay $50 in taxes regardless of the size of the account, I mean I could understand that if it’s a small account but we know people had millions of dollars. I mean $50 is nothing, but you found that it was, it didn’t matter.

Dan Egan: Yeah. This is one of the interesting things. So I actually ended up writing an academic paper on this. That people’s aversion to taxes isn’t rational. It is just a “I really don’t like taxes.” There are a number of papers that find that people will pay more than $1 to avoid $1 worth of taxes.

 Rick Ferri: And Dan another piece of research that you wrote, or participated in writing, for the Journal of Economic Behavior and Organization talked about second-order beliefs, in other words if everybody around you is optimistic thinking that the market is going up, that even though you’ve done all this great work to determine what your risk allocation should be, what your optimal asset allocation should be for your situation, people have a tendency to increase that and add more equity. And perhaps getting them over their tolerance for risk unintentionally.

Dan Egan: There’s a saying by John Maynard Keynes that the stock market is like a beauty contest. It’s not really necessarily that you’re trying to say, like if the market is overvalued or undervalued, but what do other people think. You know if you want to be able to speculate effectively it’s not a matter of being right in an absolute sense, it’s a matter of just being ahead of the crowd. And so we went out and looked at how much people thought they knew what other people were thinking, how accurate they were in those beliefs, and how comfortable they were being different from the herd.

And so one of the first things that we picked up on is that everybody thinks that the crowd agrees with them more than they actually do. So if you’re really bearish for the next quarter you’re going to believe that most people are very bearish too, and if you’re very bullish for the next quarter you’re going to believe that too. And one of the nice things that we found was that the more self-aware a person was about when their views diverged from the crowd, so you have two things, you have how good are you at understanding what the broad sentiment of the market is and are you accurate at conveying that. Number two, do you know that you are being a maverick by having a different view. That sense of self perspective and crowd’s perspective. There were very few people that had it, and the people who had it tended to have better performance.

Rick Ferri: Dan, in one of your presentations you gave to a CFA group, you talked about how exocortex of a brain, the part of our brain that does the logic and the thinking and comes up with asset allocations and so forth, that through artificial intelligence and other technology tools we are taking a lot of the decision-making, and we are letting computers do it, letting machines do it, and that this is a good thing. And that there’s a lot of things out there in personal finance that used to take a lot of thought and advisors and individuals take up a lot of time and quite frankly made a lot of mistakes. That by outsourcing it, if you will, to machines, behavior is getting better. Could you talk about that whole concept and what can be outsourced to a machine these days.

Dan Egan: One of our key advantages as a species is our ability to not only sort of use tools but also imagine and design new tools for us to use. And for a lot of history you can think about, like hammers and steam engines and so on. These were physical tools that we built outside of ourselves, and we’re just now starting to build and really, explore the use of logical tools that are able to make decisions in the real world for us. We’re still the ones building and designing them. Computers aren’t building and designing themselves quite yet. That allows me to do a lot more because I can kind of like outsource a lot of my thinking and monitoring to software, so I don’t actually know what I’m doing after this call but I’m sure that my calendar knows. My calendar is going to notify me with what I need to do next. But we’re still the ones who need to say well, like what do we want this technology to do for us, how do we want it to expand our capability?

Something you keep coming back to is that the things that computers are really good at are things that we are not good at. They’re incredibly good at doing the same thing over and over again hundreds of thousands of times. They’re very good at math. They’re very good at statistics. What they’re not good at is non-routine creative imaginative labor that understands human beings and understands the circumstances that they find themselves in. So there’s a really nice symbiosis, a yin and yang going on right there, where we can take the things that are boring and routine, things like processing trades and calculating how much to put in each asset class and looking at whether or not the taxes are going to be worth changing it, compared to the fees. We can program a computer to do that and the programming, itself, the thinking and designing of how we would go about that decision is very creative and very sort of challenging. But once we’ve done it we can have a computer execute it for lots and lots of people. 

And I sort of think this in terms of how it dovetails with advisors is that there was a period of time where advisors had to, because we didn’t have the kind of exocortex doing things for us, had to figure out how much each asset class should be bought in order to rebalance, or where the money should come from in terms of tax efficiency when you’re doing retirement planning. We knew what the answers were, we just needed to implement that thought process in a machine. 

And now that frees up advisors to spend more time with clients on the things that the computers are not going to be able to do. Sitting down with a couple and having a conversation with them about how they’re going to actually spend time in retirement, you know how much they’re going to spend every year, what the budget constraints mean, what they’re comfortable with. That’s something that you still need human-to-human back and forth on. Knowing when somebody says something but doesn’t really mean it and being able to detect that and being a good coach, a personal finance coach for them, that’s somewhere where advisors are going to excel for a long time.

And so I really like where we’re coming to now, where advisors are letting go of well, I need to be the one to place the trades and to do due diligence on all of the indices, and so on. Really sort of like detailed in the weeds labor. And they’re getting freed up to do that, which means that they are spending more time having better, higher quality conversations and doing more quality planning with the people on the other side of the table, with their clients.

Rick Ferri: I completely agree with that as far as a lot of the execution and then the implementation of portfolios. Tax loss harvesting, which has now become automated, back in the day when I was doing it ten years ago you had to do it by hand. So a lot of the things that we used to have to do by hand as advisors, machines can do it much better, more accurately, and I don’t have to spend time doing it. But not only that, human beings are expensive, an expensive commodity, so you know you can outsource this to technology. The adviser can spend more time where it’s really needed which is on the behavioral side. So that’s all good. 

Dan Egan: One of the areas that I actually think advisors don’t give themselves enough credit for is the communicating of different things to different people. So when a person comes to a website, it’s very hard for the website to know ahead of time that a football analogy would work very well for them but advisors know that different people, they can track those different people’s interests and know what kind of analogies or explanations are going to really resonate with them, such that they get a point.

Whereas a lot of times technology has in terms of communicating things a one-size-fits-all dimension. Especially during the educational and onboarding component of advising a client, advisors have a real advantage in that they will communicate more effectively and more efficiently with each individual client because they can change the way they talk on the fly.

Rick Ferri: Hey I can give you a story about that. I was talking with a client several years ago and I made a golf analogy and I was talking about index funds, and I said, “You know, let’s say you went out on the golf course and every time you went out on the golf course you shot par every single time.That would be great, wouldn’t it.” And I was asking this woman and she said, “I don’t play golf and I have no idea what you’re talking about.”

[laughs] But you’re right. I mean if we have a questionnaire where it says you know what are your hobbies, and somebody wrote down golf, I could use that analogy with that person.

Dan one of the other things that you do at Betterment which I find very interesting, and I learned a lot from listening to one of your presentations, is that when you’re talking about goals with clients, in other words, what do you want your money to do for you, where do you want to go, that people have a really difficult time articulating or defining what their goals are. So you sort of reversed all that. You’ve come to the realization that most people have common goals and that it’s better to have them eliminate goals rather than say what the goal is. Can you talk about how you came to that conclusion.

Dan Egan: Yeah I think there’s two inputs to this, or two reasons we ended up here. One is just the general idea that we can learn a lot from each other. One of my favorite books that I’ve read over the last year was 30 Lessons for Living From the Oldest Americans. They speak to a 70, 80, 90 year olds about what they think went well in their life and what didn’t go well and what they would go back and change across career and marriage and being a parent, and I think we really need to do a better job of learning from each other and using the wisdom that’s available to us from a wide array of other people. 

One of the things that we’ve been doing is looking at how clients use our platform, looking at what goals our CFPs recommend to people. And rather than trying to reinvent the wheel every single time for each client and putting the weight upon them to do it, well wait we know what goals our CFPs are going to recommend for somebody who’s in their early 20s, and we know how they would go through a budgeting. We know that they’re the ones if you are in your mid-20s and not yet married, you know maybe you need to start thinking ahead to the kind of goals that come up later, whereas if you’re in your mid 50s and you’ve already kicked the kids out of the house you have a different set of goals.  The other element of it – and we start with it – we have a really good kind of, like, wise set of goals that come up from the experiences of lots of people through time. The other element of it is that, as you said, people have a hard time coming up with those goals themselves, where they’re in the future. I know I could go back now and tell 25 year-old me things he should be thinking about;  but 25 year old me would feel it was very hard for him to think ahead. So rather than have people try and, you know, come up with and imagine and brainstorm the things that they might need to spend money on over the next 5, 10, 15, 20 years, we put them there in front of them and say, “These seem like they’re the things that you need to be thinking about. Why don’t you remove any that you know aren’t applicable to you and we can work through prioritizing the rest of them.”

That’s a lot less effort on the individual. Generally speaking people who are given a kind of master list of goals that they remove from end up with twice as many goals that they want to be planning for compared to somebody who you force to start from scratch. So it’s a very effective way of helping people identify what goals they think they should be planning for based on the wisdom of the crowd. And it also means that those people are better set up to invest intelligently for the future because instead of saying, well I’m going to assess performance by whether or not my account went up and down, they say well I’m going to assess performance based on whether or not I’m track to hit these personal finance goals that I have. 

Rick Ferri: One of the questions I have for the future of FinTech, using technology to become better investors, is the shift that is going on with the, and if you don’t mind me saying robo-advisors, I don’t know how you feel about that phrase being that you.

Dan Egan: Go for it.

Rick Ferri: Okay, is that you know they’re set up for young people who are just getting started. And you know how to do a budget, put a few bucks a month away, get him into index funds. All that’s very good. Get him investing. They’re going to need to learn how to invest and this is a great way of doing it. 

But one of the things that I always found lacking, at least at the beginning of all of the robo-advisors is it was for that other generation, it was for the Millennials. It wasn’t really for my generation, which is the baby boomer generation who are retiring. So a lot of the tools that were created were for the accumulation of assets, and I believe the next phase of all this is how do you provide tools for people like me who are 60 years old and the distribution of our assets in retirement. It seems to me that that’s the next phase of this whole robo advising world?

Dan Egan: It’s definitely going to happen. I’d say for three reasons.One is that myself and the current crop of people, we get one year older every year and that steady march, you know, we’re good at building for ourselves because we kind of know what we need at this point in our life. The closer we get to retirement the more that we hear about and want those sets of tools for ourselves. I already have these discussions with my parents and understanding what they need is really important. On the flip side of the market is the consumers, my parents, are very uncomfortable with the idea of just using a digital investment solution because they want to be able to talk to somebody, because they want to have them communicate and one person that they know face-to-face.

The younger generations, you know they go both ways. I think there’s a mix of it, but they’re more likely to be comfortable with a purely digital solution and less feel like they need a face-to-face contact. That might change over time as the cohort gets older. Either way I think that we’re going to see greater adoption of sort of decumulation in retirement software and planning as people who grew up with computers and who have been using them their entire white-collar professional life are going to want that same thing in retirement as opposed to a generation who might not have.

And I think to your point there are more people who are even right now starting up companies that are focused on retirees to try and help them make those decisions. One of the interesting components of it is when you look at a business that has a target customer that is accumulating money over time they kind of have positive growth curves built into their customers. A retiree focus product is looking specifically at customers who are reducing their wealth over time. So I think there’s going to be an interesting kind of like, they’re going to want to look at different compensation models for that kind of advice to dovetail better with the incentive schemes that are present specifically for retirees and how they are going to be spending their money and managing their assets.

Rick Ferri: I completely agree with you. The company that I’m starting is hourly-based advice where I’m not actually going to be implementing anything. I’m just going to be talking with people and getting paid for that intellectual property and when it comes to the actual implementation use these tools such as Betterment and others to actually implement the clients’ portfolios at a very low cost. 

So it’s getting back to what you’re saying. At some point people need or want that human interaction.They want that second opinion. They want to run it by somebody and get input but it doesn’t need to be ongoing. It doesn’t need to be every quarter or every year. So the pricing model on that type of advice needs to reflect the way it’s used as opposed to say just assets under management.

There’s advisors that are charging one percent per year and then clients are not utilizing one percent per year worth of advice. They might use it one year but for the next two or three years they don’t need it. So I think the pricing models and the way it’s delivered, there’s going to be a separation between the advice givers who get paid for the advice and the implementers who get paid for managing the portfolios as a difference in the way that the services are delivered. And Betterment has already started to go down this path because now you’ve implemented a financial planning and advisory model.

Dan Egan: Betterment started out just charging 25 basis points to our retail clients and over the years we learned that number one, some people wanted more of a CSP engagement. We found that there’s a lot of upfront cost. So we have to get to know them, gather all their data, understand their circumstances, and then have one or two calls with them. And then they didn’t want to start again from scratch later, so we started offering what we called Betterment Premium, which was 40 basis points instead of 25 basis points, and it was an annual fee, so that you were kind of locked in for one year at 40 basis points rather than 25. And the uptake on that was just of a very specific person who wanted kind of like, that ongoing relationship where they wanted to be able to call us any time, which was a subset of people.

I think a lot of people think like you think, which is well, actually I just have this specific question that I want answered and some guidance on, and I don’t want that to translate into this long ongoing relationship. So about six months or a year ago we started offering what we call “advice packages” which are modular little a la carte packages you can buy. Like I’m getting married and I want to understand what’s involved in merging our finances and the options there; or planning for a kid’s college education; or optimizing Social Security and retirement. These are questions that the person doesn’t feel like they need advice tied to their assets in any way, but they do want, as you said, a conversation with an expert, somebody to take a look at it, check their work, make sure that they’re doing the right thing, and then once they have that confidence, maybe help them set up a bit of the execution for it. Maybe set up goals in their Betterment account.

And we found that that’s been very effective, the most common package that people like is actually an initial getting set up and checkup package, where they’re just going to pay us I think something like $200 for us to look at their information, set up their Betterment account the right way, check that everything’s right, have a conversation with them and their spouse about it and then they’re confident. Then they’re ready to like, have it run on the 25 basis points for the rest of the time. So I think that that kind of giving people the option to buy the level of service and the type of service that they feel is appropriate for what they want is very important.

I think that there’s room for both of them. I think there are people who want to pay an extra 25 basis points to have an ongoing relationship and feel like you’re going to be monitoring and looking at it and they can call you anytime, but they’re also people can know that they have specific discrete questions and there’s no reason for them to have an annual fee to get them answered.

Rick Ferri: I think that’s great at giving people options on how they pay for the advice that they’re getting is a great concept. Again I used to be on the all asset management side. We used to give some advice. Now just giving people different options as to how they can pay for the advice going forward whether they’re going to roll it into an asset management fee, whether they’re going to just pay for it a la carte, which is what you’re talking about. They could pay for it through an ongoing retainer that they’re paying directly to advisors such as XY Planners, a company that is doing subscription-based type planning. I mean there’s a lot of different options available to people out there now and it’s just getting better. It all better aligns the services that are being provided to the clients with the fees that are being charged to clients.  I didn’t know about your a la carte offering and I’m happy to hear that it’s going well. It does seem to be a very good way of doing things.

Dan Egan: The next level in this that I’d like to see at some point is a fee arrangement that is based upon the success of the client, so number one I wish advisors were a little bit more incentivized to take a look at clients ahead of time and see what value they could add and say I think that I can wring an extra fifty thousand dollars out of your retirement savings if we tweak things and change them, and if I help you adhere to this plan over the next ten years would you be willing to take me on as a kind of a profit share. Because I want to see you succeed and you want to see you succeed. So let’s figure out a way where advisors even going further down that incentive alignment chain where advisors are kind of equity holders in their clients’ success.And I would want to, you know, like know that I’m going to get paid, not only for like, knowing the financial planning details, but actually helping the client execute on those plans. 

Rick Ferri:  Yeah I don’t know how the SEC the Security Exchange Commission is going to feel about that. You know participating in any way in any of the clients profits, aside from AUM, which is a way of participating in their profits. Something the regulators have always looked at very negatively because it creates incentives to the advisor to take more risk in the client account. I understand what you’re saying to be an equity holder in the client’s success but what’s the downside, in other words, what if it doesn’t work. Are you also, you know, are you on the hook?

Dan Egan: Yep, there are a number of companies, now, my wife happens to be doing one of them, which is a sort of doing a career change into being a software engineer, and a lot of them are set up where they’re going to train you for three to six months and they only get paid when you are making more than $80,000 a year in a tech job and then they can make up to sort of $40,000. So I’m seeing more and more incentive, a lot of success incentive aligned commercial relationships and it’s interesting to think about and ponder how you could legally also do that for personal finance. 

Rick Ferri: Yeah so what you’re doing is deferring the fee, in other words, you know what the fee is going to be, just deferring it until you have you have success, and if you don’t have success, then the fee that you owe me would be less or maybe non-existent. So like I could understand that where the fee is upfront, this is our fee we’re just not going to collect it all, we’re just going to collect a little bit now, when we’re going to collect the rest of it later on down the road, when you are successful. I think that would be an intelligent approach, rather than just kind of a profit sharing, where we’re going to get more if you’re more successful later on down the road. It’s all interesting. 

Dan, generally in the financial services industry we separate people between delegators and do-it-yourself investors. The delegators will go out and hire an advisor, have somebody manage their portfolio, because their free time is important to them. Either they don’t want to do it or they can’t do it. But to them they’d rather not do it, they’d rather go do something else and their free time is important. The do-it-yourself investors, though, they might like it as a hobby, they might prefer to save the money of the advisor because the delegators do have to pay something, as you say 25 basis points, fair fee. But on the do-it-yourself side there’s also a cost and that’s the behavioral cost as we talked about. Can you talk about the difference between the delegators, the do-it-yourself investors and how to maybe get more do-it-yourself investors to see that the value of delegating is really worth the cost.

Dan Egan: If you’re a delegator or if you’re a do-it-yourselfer it’s easy to see the pros for your side of things and I think it’s easy to not see the cons.To be fair, if you’re a delegator maybe you don’t really understand everything that’s going on in your portfolio and maybe you’re not completely on top of it. Maybe there’s a higher chance that somebody might have you invested in a not great fund, or a high fee fund, so there are costs to being completely hands-off.

At the same time there’s a huge cost, I think, to being very hands-on. I do not tune-up my car or my bike myself. I don’t try and be my own plumber, or my own electrician, and I think that the people who spend a lot of their own time being their own portfolio manager, they might be missing out on, that number one they’re kind of valuing their free time at zero when they should have a really high value of it and they could be using that time to help other people, profitably, themselves more.

So I really enjoy building out portfolio management algorithms and working with the teams and designing them well, and I kind of think of that as like my contribution to society. If I’m a liver cell, this is the role that the liver cell plays and I rely upon all the other cells to do right by me. And if we try and be all things and if we try to be a portfolio manager and be our own financial advisor, we’re probably not going to do as good a job at it as somebody who dedicates their entire life to doing that thing. And it also means that we’re spending that time not playing with our heads, not developing our own own skill sets, our own professional network in some way that would be more advantageous to us as a whole. So I think that DIYers they might enjoy it, it might be a good hobby but I think they often miss out on the costs that they don’t see that they are paying by virtue of not delegating it.

I’ve started to note when people are a little bit cost averse in an irrational way – so I think that Jack Bogle did a great job of making us very conscious of cost but the idea that the cheaper one is definitively better when the difference in costs is so low isn’t quite true. 

I have this thing where I cut my hair at home so that I can save money, and then I realized that I actually am not as good as a professional at it and I need to go out and get a professional to cut my hair sort of every other month so that it doesn’t look too silly, and I worry about people a little bit like being too tax averse even though the costs are small, the costs are something that they can avoid and so they’re becoming kind of irrationally cost averse, too, where they’re not considering the value that they get for the cost, they’re just looking cost as a way to make the decision. 

Rick Ferri: Well Dan, this has been really an interesting discussion with you and I really appreciate you giving us all the insights that you’ve gathered seeing real people managing their money over at Betterment and we’re looking for great things from you in the future so thank you for being on the show.

Dan Egan: Thank you very much for having me. It’s been a pleasure.

Rick Ferri: This concludes the sixth episode of Bogleheads on Investing. I’m your host Rick Ferri. Join us each month to hear a new special guest. In the meantime visit bogleheads.org and the Bogleheads wiki, participate in the forum and help others find the forum. Thanks for listening.



About the author 

Rick Ferri

Investment adviser, analyst, author and industry consultant



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