Personal finance amid the pandemic has meant unprecedented spikes in user engagement with advice platforms, online budgeting tools, and trading apps. While people are paying more attention to their accounts and directing cash from tax refunds and stimulus to savings and retirement funds, they’re also testing technology and resources that have become available “free of charge” since COVID-19.
There are many incredible resources available amid this crisis, but we need to keep an eye out for free resources that may have a negative impact on our performance.
Today, the many facets of our lives—exercise, laundry, groceries, and even our credit—correspond to an app on our phone. As a behavioral scientist in the world of finance technology, I find that it has a lot to do with convenience—we’re attracted to quick, easier decisions, even if they’re bad for us. We’re looking for the quick solve, which can sometimes mean sacrificing transparency behind the ways apps commoditize us as users.
The reality is that free is not always as good as it sounds. Instead, when it comes to managing your finances, free can actually cost you.
Where our brains go at hearing “free”
Our brains treat “free” differently because it’s not clear what we’re giving up. When we’re getting something free, we aren’t parting with any money, so we don’t have to go through an entire “Is this worth it?” thought process. When something is free, we don’t consider the nonmonetary costs such as time, effort, and quality. As a result, things that are free are generally overconsumed. Think about how much more you eat at a buffet than you would otherwise. As many of us are experiencing unprecedented stress around our finances with fewer avenues to blow it off (think other avenues of so-called easy profit, like spectator sports and gambling), the concept of “free” may be even more enticing.
Once we take price out of the equation, we’re actually not very good at discriminating between the quality of goods or services. Imagine that you’re at the store and standing in front of a shelf of red wine, but none of the bottles have price tags. Only those of us who happen to be expertly trained would possibly be able to figure out the actual quality of each bottle.
While we would normally count on the cost of something to indicate its caliber or quality, we can’t do the same with free items or services.
The real financial consequences of “free”
Take, for instance, how brokerage firms are approaching their money-making strategies.
While I’m not aware of any brokerage companies offering free wine, there are some that offer free trades. Even before the pandemic, we saw the “race to zero.” Almost all brokers cut their commissions until there were close to no fees across the industry.
However, these companies aren’t charities, and the fact that they offer free trades isn’t a coincidence: Brokerages often make money through other avenues than just you, the investor. Since you aren’t always the “paying customer” anymore, services aren’t designed to optimize your investment performance; they’re designed to optimize their profit from those who pay them.
These other potential avenues of profit include making interest on your cash balances, selling you trades for worse execution, or trading your data to hedge funds.
In the background, brokerages may be accepting payment from fund managers in exchange for various advantages or accepting payment for order flow from high frequency trading firms. The list goes on and on.
That’s why when things are free, we need to look for where we’re being “nudged.”
A gentle nudge toward differing interests
Richard H. Thaler, Nobel Prize winner in behavioral economics, explains that nudges are “small design changes that can markedly affect individual behavior.” Thaler urges companies designing consumer products to “nudge for good.” His words translate to never misleading a customer and practicing transparency, allowing an easy opt-out of the nudge, and ensuring each nudge leads to a positive improvement to people’s welfare.
Brokerages that offer free trades are often designed to encourage actions that are likely to reduce your success without you even knowing it. They aren’t evil—they just want to make more profit for themselves, and they don’t care if your portfolio is collateral damage.
When we take a closer look, we can see how these companies may have an incentive to nudge you to do things that aren’t in your best interest. For example, if the app encourages you to trade more it could lead to more transaction costs, more turnover, and—ultimately—more stress. If you’re nudged to hold more low-yielding cash, you lose the chance to grow that money more elsewhere. Finally, if an app nudges you to hold or trade securities that they profit on, this could increase your fund expenses and even hurt your overall portfolio. Clearly, what’s best for you isn’t necessarily what’s best for these firms.
The British art critic and pundit John Ruskin once said, “It’s unwise to pay too much, but it’s worse to pay too little. When you pay too much, you lose a little money, that’s all. When you pay too little, you sometimes lose everything, because the thing you bought was incapable of doing the thing it was bought to do.”
There are good free things: fresh air, sunshine, and time with friends come to mind. Nevertheless, over the years, I’ve learned that practicing wariness toward those offering free things is key.
These low-cost products usually ended up costing me more in time, stress, and mistakes than if I opted for something of higher quality and value.
Dan Egan is the managing director of behavioral finance at money management firm Betterment.