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Aging and the Impact of Cognitive Decline on Investment Decisions

Does the wisdom of age outweigh the other limitations it can impose?

The U.S. investor population is both aging and living longer, creating the need for financial assets to last longer. An important question to address is whether the wisdom gained from experience is greater than the negative impacts on investment behavior caused by the decline in cognitive skills as we age. The empirical research shows that while, on balance, cognitive decline has the greater impact, it’s 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 equities. Older investors also tend to trade less frequently—a good thing, as the 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 soon (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 worse investment skill, especially if they are less educated, earn lower income and belong to minority racial/ethnic groups.” The authors also found that the stocks such investors own tend to lag the market by ever-increasing amounts as they grow older. They noted: “The age-skill relation has an inverted U-shape and, furthermore, the skill deteriorates sharply around the age of 70.” The study found that “on average, investors with stronger aging effects earn about 3% lower risk-adjusted annual returns, and the performance differential is over 5% among older investors with large portfolios.”

Michael Finke, John Howe and Sandra Huston, authors of the study Old Age and the Decline in Financial Literacy, found that while financial literacy scores decline by about 1 percentage point each year after age 60, confidence in financial decision-making abilities does not decline with age. Thus, they authors concluded that increasing confidence and reduced abilities 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 declining cognitive abilities.

New Research

Fabrizio Mazzonna and Franco Peracchi, contribute to the literature with their study Are Older People Aware of Their Cognitive Decline? Misperception and Financial Decision Making, in which they investigated whether older people correctly perceived their own cognitive decline and the potential financial consequences of misperception. They used data from the bi-annual Health and Retirement Study (HRS), a representative panel of about 20,000 of the U.S. population aged 50+, to study the relationships between self-ratings of memory changes, assessed changes in memory performance and wealth changes. They restricted the sample to people aged 80 years or less, so most respondents did not experience the extreme cognitive decline typical of neurological pathologies. Since wealth changes were defined at the household level, they restricted attention to the household member who was most knowledgeable about the household finances. Here is a summary of their key findings:

Older people tend to be unaware 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 initially in very good health were more likely to be unaware of their memory decline—the unaware appear to have better initial health and memory, perhaps explaining why they remained confident about their skills.

Those unaware of their severe cognitive decline suffered large wealth losses compared to respondents who were aware or did not experience a severe decline. Such losses were mainly concentrated among respondents who were unaware of their declining memory performance—equal to about 10% on average in the real value of financial wealth—and were much larger among respondents who were active on the stock market in the previous two years.

There were no comparable wealth losses among respondents who were aware of their declining memory, or among respondents who were unaware but were less likely to make financial decisions in the household.

Their findings led Mazzonna and Peracchi to conclude: “People tend to substantially underestimate their cognitive decline and we document the financial consequences of misperception. We find that respondents who are unaware of their cognitive decline are likely to experience larger financial wealth losses compared to those who are aware or did not experience a severe decline… Our insufficient understanding of cognitive decline, and of human capital decumulation more generally, is unfortunate because cognitive functioning influences an individual’s ability to process information and to make the right choices.”

Investment Takeaways

It’s important for investors and advisors alike to consider the likelihood 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 should be put in place before cognitive decline begins. This is especially important considering the findings that older investors are often unaware of the decline in their cognitive skills and, thus, are more likely to be overconfident about their ability.

The consequences of cognitive decline are likely to be even worse for those with high initial levels of cognitive ability, who tend to directly manage their finances and, therefore, don’t seek advice due to their high level of confidence. Plans should include granting powers of attorney for financial and health care matters to trusted family members or professionals. And these documents should be reviewed on a regular basis to make sure they are up to date.

Larry Swedroe is the author of 18 books, the latest of which is Enrich Your Future: The Keys to Successful Investing

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