The US investor population is aging and living longer, creating a need for financial assets to last longer. An important question to address is whether the wisdom gained from experience outweighs the negative impacts on investment behavior caused by cognitive decline as we age. Empirical research shows that while, on balance, cognitive decline has the greatest impact, it is not entirely one-sided.
For example, research has found that as investors age they tend to have more diversified portfolios, own more asset classes and have higher allocations to international stocks. Older investors also tend to trade less frequently—a good thing, since evidence shows a negative correlation between individual investors' trading activity and their returns. They also tend to be less affected by behavioral errors, such as selling winners too quickly (the disposition effect) and local bias (the familiarity effect). And they tend to own mutual funds with lower expense ratios—another good thing. These choices reflect greater investment knowledge.
On the other hand, George Korniotis and Alok Kumar, authors of the study Do older investors make better investment decisions?, found that “older investors are less effective in applying their investment knowledge and exhibit poorer investment skills, especially if they are less educated, earn lower incomes, and belong to racial/ethnic groups minorities”. The authors also found that stocks owned by such investors tend to lag the market by increasing their amounts as they grow. They noted: “The age-ability relationship has an inverted U shape, and furthermore, ability deteriorates significantly around age 70.” The study found that “on average, investors with stronger aging effects earn about 3% lower annual risk-adjusted returns, and the performance gap is over 5% among older investors with large portfolios.”
Michael Finke, John Howe and Sandra Huston, study authors Old age and the decline of financial literacy, found that while financial literacy scores decline by about 1 percentage point each year after age 60, confidence in financial decision-making skills does not decline with age. Thus, the authors concluded that increased confidence and reduced skills explain poor investment (and credit) choices by older investors—age is positively related to financial overconfidence. And overconfidence can be a deadly sin when it comes to investing. Adding to the problem is the tendency for older people to reject evidence of cognitive decline.
New research
Fabrizio Mazzonna and Franco Peracchi, contribute to the literature with their study Are the elderly aware of their cognitive decline? Misperception and Financial Decision Making, in which they investigated whether older adults correctly perceived their cognitive decline and the potential financial consequences of misperception. They used data from the biennial Health and Retirement Study (HRS), a representative panel of approximately 20,000 US population aged 50+, to study the relationships between self-reported memory changes, estimated changes in memory performance, and changes in wealth. They limited the sample to people aged 80 or younger, so most respondents did not experience the extreme cognitive decline typical of neurological pathologies. Since wealth changes were determined at the household level, they limited attention to the household member who was most knowledgeable about household finances. Here is a summary of their key findings:
Older people tend not to be aware of their cognitive decline—about 80% of those who experienced severe memory loss between adjacent waves actually rated their memory as stable or improved.
Education, wealth, and health were negatively associated with the probability of experiencing severe memory loss. However, these “protective” factors were only weakly associated with the probability of being unaware. As an example, respondents with higher initial memory scores or in very good initial health were more likely to be unaware of their memory decline—the unaware appeared to have better initial health and memory, perhaps explaining why they remained confident of their abilities.
Those who were unaware of their severe cognitive decline suffered greater wealth losses compared to respondents who were aware or did not experience a severe decline. Such losses were concentrated among respondents who were unaware of their declining memory performance—equal to about 10% on average in the real value of financial assets—and were much greater among respondents who were active in the stock market in the previous two years.
There was no comparable wealth loss among respondents who were aware of their memory decline, or among respondents who were unaware but less likely to make household financial decisions.
Their findings led Mazzonna and Peracchi to conclude: “People tend to significantly underestimate their cognitive decline, and we document the financial consequences of the misperception. We find that respondents who are unaware of their cognitive decline are likely to experience greater losses of financial wealth than those who are aware of or have not experienced a severe decline… Our insufficient understanding of decline cognitive and decumulation of human capital in general, is unfortunate. because cognitive functioning affects an individual's ability to process information and make appropriate choices.”
Investment agreement
It is important for investors and advisors to consider the possibility that financial decision-making skills will eventually decline, creating the potential for poor decisions. Compounding the problem is that older people with cognitive decline are more likely to become victims of financial fraud. Thus, plans must be put in place before cognitive decline begins. This is particularly important given the findings that older investors are often unaware of their cognitive decline and are therefore more likely to be overconfident about their abilities.
The consequences of cognitive decline are likely to be even worse for those with high initial levels of cognitive ability, who tend to manage their finances directly and, therefore, do not seek advice because of their high level of cognitive ability. faith. Plans should include giving power of attorney for financial and health care matters to trusted family members or professionals. And these documents should be reviewed regularly to ensure they are up to date.
Larry Swedroe is the author of 18 books, the latest of which is Enrich your future: the keys to a successful investment.