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Ep 6: Advisers and investor behaviour
301 Plays2 years ago
Daniel Egan is Vice-President of Behavioural Finance and Investing at Betterment, the New York City-based automated investment service, or robo-adviser.
Although new robo-advisers are launching all around the world, almost without exception they’e struggling to make anything more than modest profits. That notwithstanding, I do believe that automated and partially automated investing are the future; and also that robo-advisers can happily coexist alongside traditional face-to-face advisory firms. More than that, I think that human advisers and robos can learn from each other.
What I was most keen to ask Daniel Egan about is the research that Betterment has done on how to curb destructive investor behaviour, and what the lessons of it are for traditional advisory firms.
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Transcript
Introduction and Guest Welcome
00:00:05
Speaker
Hello and welcome to the latest Tebbe podcast brought to you by Regis Media. I'm Robin Powell. You may be familiar with me from my blog, The Evidence-Based Investor. This week, my special guest is Daniel Egan, Vice President of Behavioral Finance and Investing at Betterment, the US-based Automated Investment Service, or ROBO, advisor.
Why Do Investors Underperform?
00:00:31
Speaker
Effectively, Daniel is in charge of integrating how Betterment's investment strategy is crafted, communicated and delivered to its customers. As no doubt most of our listeners know, there are two main reasons why investors consistently underperform the market.
00:00:50
Speaker
The first is cost. They buy expensive funds they don't need and the vast majority of which fail to beat their benchmarks over meaningful periods of time. The second reason is investor behaviour, our tendency to act when in most cases we'd be better off doing nothing at all.
Betterment's Approach to Investor Behavior
00:01:11
Speaker
What really impresses me about Betterment is the priority it gives to tackling those two problems. First, it uses low-cost index funds which, over time, saves customers a fortune in fees and charges. Secondly, it goes to considerable lengths to discourage destructive investor behaviour. That is very much Daniel's department.
00:01:35
Speaker
One of the things that we focus on is our investors. People often talk about investment management and we like to focus on investor management. One of the things that we can do, which is a little bit unusual, is to run randomized controlled trials, i.e. tests, about whether or not what we are communicating and how we are communicating with customers is helping them.
00:01:56
Speaker
We have over 200,000 customers and we have a lot of ideas about how design and very small tweaks can influence and change people's perception of investing and of their investments. So we like to run experiments to see that we know we are making a positive impact on their outcomes and we use a scientific design much like what the FDA uses to understand if we're having
Impact of Tax Information on Investor Decisions
00:02:19
Speaker
the right impacts.
00:02:19
Speaker
One of the most common behavioural flaws investors are prone to is the tendency to tweak and tinker with asset allocation far more often than we should. But using the kind of trials that Daniel has just explained, Betterment has apparently had real success
00:02:37
Speaker
in encouraging investors to leave their portfolios alone. A great example of this, we have a couple. Number one, we released a feature called Tax Impact Preview a couple of years ago. And we ran it in a split test for about three weeks to see how it would impact investors' behavior.
00:02:55
Speaker
What tax impact preview does is when you're going to change the allocation or make withdrawal, in real time it'll calculate how much tax you will owe the following year because of those transactions due to capital gains both short term and long term. And it gives the investor that number in real time before they go through with the transaction. A little bit of information that's really relevant right when you need it.
00:03:17
Speaker
And what we found was that putting that information in front of them reduced allocation changes dramatically by generally about 75% and reduced the rate at which people incurred taxes over $50 by about 90%. So giving customers real-time information that changes their behavior allows them to make better decisions. And it was done in a very scientifically rigorous fashion.
Strategies for Communication During Market Volatility
00:03:40
Speaker
One of the biggest risks investors face is the risk of capitulation, the danger that they'll abandon equities during or shortly after a crash or correction. Betterment recently conducted some research into how client communication in times of market upheaval can help or sometimes hinder investors in making rational decisions.
00:04:02
Speaker
Betterment has lasted through about four or five market corrections, a drawdown of 10% or more over its history. And I like to say that there are very few people who look forward to market corrections, but a behavioral scientist is one of them, because that's when we get to test whether or not what we're doing is helping customers. So every time there is a correction, we actually try and tweak what we're doing. One of the first ones was whether or not you should reach out to your customers. Should you email them about what is going on?
00:04:29
Speaker
So we ran again a test of our strategies to see how it was being effective. We emailed, we broke our customer base into quarters and didn't email a quarter of them and emailed the other three quarters with three different messages. So what's going on in the markets or how you should stay the course during rough markets. And what we found was that the customers who did not receive an email
00:04:51
Speaker
we're the ones who are least likely to make a change. So by causing the conversation, by starting the conversation with that outbound communication, you are more likely to disrupt the customer's life and make them anxious about something. And we've actually changed the way this works now, where we still message customers, but only once they've logged into the website. So it's targeted to people who are actually concerned.
00:05:13
Speaker
Those findings certainly chime with what advisors have told me. There are some clients who simply don't need to be reminded of how important it is to stay the course. For those who may be tempted to capitulate, the right messaging, the right content, at the right time, might just stop them doing something they'll come to regret later.
00:05:34
Speaker
What advice would Daniel give then on this subject to more traditional advisory firms? I think one of the key things is have the right content ready to go ahead of time. Scrambling, having yourself be panicked or not prepared right when the customers need you to be there for them.
00:05:53
Speaker
If you haven't prepared, it's too late and you want to be very careful. If you have the content ready to go, if you thought through what your playbook is going to be during a rough circumstance, then it's all about execution and the customers will really appreciate the quality and execution of that service to them.
Ignoring Market Noise: Brexit and US Election
00:06:08
Speaker
In recent months of course the temptation for investors to act on their emotions has been particularly strong. First there was the Brexit referendum in the UK and then Donald Trump's victory in the US presidential election. For Daniel Egan both of those events illustrated the importance of shutting out the market noise and refusing to speculate on what might happen.
00:06:33
Speaker
I think there are wonderful learning opportunities. In both cases, we had very strong forecasts, very confident forecasts, not only of what the outcome was going to be, but the consequences of the outcome. I think here in the US, after the election, number one,
00:06:48
Speaker
Most polls were heavily favoring Hillary Clinton to win, and that didn't come to pass. And critically as well, if Trump won, it was predicted that stock markets were going to crash heavily. And that likewise didn't happen. So I think the learning experience for investors was, number one,
00:07:05
Speaker
Be skeptical of people who say that they can forecast the future. It's important to be diversified to reduce your kind of concentrated risk that could ruin you if you're wrong. You want to hedge all of your bets. And number two, don't mix politics and portfolios because it's doubling down on a sentiment and an affect that actually tends to lead you astray.
00:07:25
Speaker
You're listening to the Tebbe podcast with me, Robin Powell, speaking to Daniel Egan from the US RoboAdvisor Betterment. We'll be back in a moment after a brief message from our sponsor, Regis Media.
00:07:38
Speaker
Hi, Sam Lewis here from Regis Media. We provide video content to advisors all over the world. We want to ensure your videos have the greatest possible impact without adding further demands on your time. With this in mind, we've created Regis Plus. We manage your social media channels for you, posting a mix of branded video and graphics, and articles that we curate from trusted sources to build an engaged audience.
00:08:03
Speaker
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00:08:22
Speaker
Welcome back. Before the break, we were talking about the two big political stories of 2016, Brexit and the election of Donald Trump. Of course, the dust has started to settle after both of those events, but there is still huge uncertainty, particularly about the future of Europe, and perhaps more concerning about international relations more generally.
00:08:46
Speaker
What would Daniel Egan's message be to investors now?
Planning for Uncertainties and Risk Management
00:08:50
Speaker
I like to think that now we have known uncertainty. You know, it's often the really big events are ones that you didn't see coming. And those risks, those uncertainties always exist. If it's a natural disaster or something that we didn't see coming, here we have a set of known uncertainties that we can manage, that we can think about. And I think that having a plan and being prepared, especially for those things, is helpful.
00:09:12
Speaker
But it's very important to not get caught up in events as they happen, to have thought it through in a cold, rational state ahead of time, so that when something happens, you're simply executing a prethought-out plan. So having a plan is hugely important. I would certainly agree with that. But what can investors do on an ongoing basis to manage their own behaviour?
00:09:34
Speaker
The most helpful thing investors can do is to set themselves up for success by planning ahead and taking themselves out of the day-to-day decision making as much as possible. So a very simple example that I give about myself is I often try and run into work. I do not try and pick out my outfit in the morning when I haven't had a cup of coffee before I run into work. I do that the night before, so that in the morning, I'm tired, but I just know what I have to do. I put on my clothes, I go for a run, and I come back.
00:10:01
Speaker
I think that we don't want to have to be constantly making decisions about our portfolios. We should set out a set of principles. Here's how I'm going to do this in the future. I'm going to live by these principles. Number two, set up a process by which you will do that. I'm going to check in every month. Ideally, I'm not going to check it at all. I think a lot of people should be using automated solutions that take those principles and make machines do them, make a better use of their time.
00:10:27
Speaker
And then finally, I'm not going to try and react to things as they happen. Generally speaking, reacting in the heat of the moment is the worst time to be doing something. So unless you're somebody who is completely cold and rational when these things happen, it's always good to take a deep breath, take a step back and cool off.
00:10:45
Speaker
What then about Betterment itself?
Betterment's Expansion and Robo-Advisor Sustainability
00:10:48
Speaker
As a company, how's it doing? Unsurprisingly, Daniel Egan is very upbeat. One of the brightest spots for us right now is that we have our direct-to-consumer business, which has been going for five years now, is the largest independent automated investment service out there.
00:11:07
Speaker
The wind at our back with the Department of Labor's fiduciary rule, with the changes that are happening in the financial industry, they all play directly to our strengths of being a fiduciary advisor. Going along with that, we're now able to offer it to plan sponsors, i.e. companies who have a 401K, through the Betterment for Business line of business.
00:11:24
Speaker
Whereas previously individuals had to directly choose us and they could still have a very expensive 401k through their company We're seeing a lot of betterment customers sell their company on having a betterment 401k So all of these point towards betterment becoming a broader supplier of the independent financial advice that people need financial planning and investment management for low cost and delivering it through multiple channels where people need it and
00:11:52
Speaker
Of course, we're seeing more and more robo-advisors around the world, but there's little evidence yet that robos are making a serious dent in the market. Yes, they're helping consumers, but they're struggling to make big profits. Daniel insists, though, that robo-advice is a viable business model and that robos and traditional advisors can happily coexist.
00:12:15
Speaker
I think there are three core aspects that make a robo-advisor proposition sustainable. One is definitely scale. Being a robo-advisor in America with a much larger financial market and a very amenable consumer base, they're okay with passive investing. They don't mind doing things online. That's given us a lot of tailwind to grow quickly and have a very large potential scale within the country.
00:12:41
Speaker
On the other hand, I think while people focus a lot at delivering exactly the same thing as has been delivered to high net worth people, but at lower cost, that's just one side of it. You also actually need to use technology to do things better. You need to provide services that it would be very difficult for a human being to deliver.
00:12:59
Speaker
we have things like tax lost harvesting and asset location, which is mathematically incredibly complex and involves looking at the portfolio across 12 different holdings every day. This is exactly the kind of job that a computer can do extremely well, but that it would be very inefficient to use a human or impossible to use a human. So I think that it's important to not try and have a robo-advisor replace a human advisor, rather focus on the things that technology and automation can do
00:13:28
Speaker
far better than humans and work with them, if they're financial planners or advisors, to deliver that to all consumers. And on that positive note, it's time to draw this latest Tebi podcast to a close. Thank you to Daniel Egan from Betterment and to our sponsor Regis Media. You can find out more about Regis Media and its work with advice firms around the world by visiting regismedia.com.
00:13:55
Speaker
There'll be no podcast next week because of a certain festive event, cue appropriate music. Whatever you're doing this Christmas, season's greetings to all our listeners and very best wishes for a happy, healthy and prosperous 2017. From me, Robin Powell, goodbye.