Free Trading Apps Are Like 'Poison Wrapped in Chocolate'

Dan Egan, director of behavioral finance and investing at Betterment, joined The Long View to discuss how Betterment helps close the investor behavioral gaps, the use of free brokerage apps, and challenges new investors in the pandemic are facing.

Here are a few excerpts from Egan's conversation with Morningstar's Christine Benz and Jeff Ptak:

Inexpensive Is Better Than Free

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." Why, in your opinion, are free trading services and free index funds problematic?

Egan: 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. 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 like Hershey's Kisses for $0.01. So, $0.14 difference between them. And you say, "Well, you know what, a Lindt truffle for $0.15 isn't bad, I'll take one of those," 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 reasons: 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.

New Investors and Robinhood

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, and many of them are using these free trading services like Robinhood HOOD 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. 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 in 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 back-and-forth things here. 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. 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. We did a study a little while ago and 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, 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 a 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.

This article was adapted from an interview that aired on Morningstar's The Long View podcast. Listen to the full episode.