Posted on January 7, 2015 by Courtney Windler

How has technology changed investment management? What are my online investment options? How can I easily create a portfolio of investments that align with my risk preferences? I had the opportunity to speak with Dan Egan, Director of Behavioral Finance and Investing at Betterment, to address these questions and learn more about how Betterment is redefining the retail investment landscape.

What is Betterment?

Betterment, headquartered in New York, is an online investment management platform that provides investment advice and fully automated diversified investment management to customers while charging fees that are much lower than those levied by traditional investment advisors. They offer both taxable and tax-advantaged retirement accounts composed of portfolios of stock and bond indexes. With Betterment, you cannot invest in individual stocks; rather you can invest generally in the stock market through instruments known as exchange-traded funds (ETFs). Customers can tailor their investments to meet unique needs and specific goals. Whether it’s a college fund or vacation account, Betterment will use guidelines such as time horizon, liquidity requirements and risk tolerance to advise on a diversified investment portfolio of ETFs to achieve these goals.

Online wealth managers such as Betterment are often referred to as robo-advisors, but Dan argues that algo-advisors is a more appropriate term to use. The service they provide isn’t performed by robots, but rather based on key algorithms that appropriately allocate investments based on your unique investor profile.

Algo-advisors and the over-due impact of technology on investment management

Humans play the more important role of figuring out what questions to ask. Dan elucidated this by applying an interesting quote from Pablo Picasso: Computers are useless. They can only give you answers. We have seen incredible progress in the development of artificial intelligence with Deep Blue beating Garry Kasparov in chess and Watson winning Jeopardy in 2011. In that sense, it’s actually strange that it has taken this long for computers to find their place in investment management and other financial services. For Betterment, computers serve to perform the algorithms that exist in an advisor’s head more quickly and precisely, and with less bias.

Who uses Betterment?

Betterment customers are interested in building for the future and are looking to make investments to do so. An intuitive interface and mobile offering make Betterment easy for anyone to use. In fact, they have seen a large influx of pre-retirees who are planning for retirement five to ten years down the road. While the younger generation may have a natural affinity for services like Betterment, Dan doesn’t view the typical customer as millennials, or any other stereotype, but rather anyone with the following three qualities:

1. They are comfortable managing their money/wealth on the web
2. They are looking for an index-tracking approach to investing
3. They want to save time/money and be more effective than DIY

I was most interested in the first quality and curious to know if that served as a barrier to attracting new customers. Dan doesn’t seem to think so and highlighted the well-designed interface and low fee structure as value propositions to investors. Customers of Betterment and investors in general exhibit a wide range of financial literacy. Betterment’s easy to navigate interface offers full reports as well as Reader’s Digest versions to explain their investment advice and practices. People have different financial circumstances and levels of comfort so Betterment makes sure to offer strategies that can make everyone better off. Dan argues that Betterment is the least expensive option for most investors, so investors seeking an index-tracking approach see the highest return when using Betterment simply because their fees are much lower than those charged by the average investment advisor.

Betterment also offers tax loss harvesting (TLH+) to ensure investor returns are maximized. Put simply, tax loss harvesting involves the sale of a security that has experienced a loss and the use of that loss to offset taxes on both capital gains and income. No one likes paying taxes, Dan points out, so Betterment also makes sure to show customers the tax implications of their investment decisions so that they can understand their final returns after taxes.

Understanding risk and new metrics for measuring it

Understanding and creating portfolios based on risk are key to the success of any investment manager, whether it’s an human investment advisor or an algo-advisor. Traditional investment advisors typically use a series of questions to identify risk tolerance and then create portfolios that they think align with this tolerance. Dan believes this is where an advisor can become a liability, in some cases. The portfolio is formed with input from two humans, the investor and the advisor, and can inevitably reflect the preferences of the advisor rather than the client. There is an unconscious bias at play that may cause a portfolio to be more customized to the advisor than to the investor. A computer will never display any behavioral bias and an algorithm can better tailor to the investor and ensure that the portfolio is customized to their specific goals and risk tolerance.

Betterment focuses on its customers risk capacity and caters portfolios to meet their needs. They are able to leverage unique metrics such as the number of times a customer logs in to check their investment to estimate the risk tolerance of customers. This feedback loop, which also includes such metrics as the frequency with which customers update their portfolio allocation, provides Betterment with relevant data to consider when measuring risk tolerance and the ability to ultimately better serve their customers.

The competition and how traditional investment management firms are responding

Online investment management and the FinTech space as a whole have both seen tremendous growth over the past few years, so Dan and I spoke about some of Betterment’s competition. Wealthfront is their main competitor, but traditional investment management firms such as Charles Schwab have also announced plans to offer online investing similar to Betterment, but without fees. On traditional investment management firms, Dan shared the following thoughts: It’s very hard to be concerned about something that doesn’t exist yet. And about something that is essentially mimicking the innovation we’ve done. Schwab had 40 years to come up with our suite of features and services, and didn’t. To that point, Betterment puts the customer first and is focused on continuous improvement of its product and services.

What’s next for Betterment?

Dan wasn’t able to share too much, but he did let me know that there are more and more new products and services coming our way — everything from personalization to making more complex and sophisticated investment management services that are usually only available to the very rich — now available to everyone.

Conclusion

Betterment is clearly helping make retail investing easier to understand, more sophisticated and more accessible for everyone. Whether you’re intimidated by the stock market or just don’t have the time to do the necessary research, their algo-advising approach could be the solution.

Courtney Windler is a first-year MBA student at the Wharton School. With experience in financial services and an interest in technology, she joined Wharton FinTech to further explore how technology is impacting the evolution of consumer financial products.