May 12, 2017 -

Posted at 12:12 pm News/Resources

There’s an adage that with age comes wisdom. But do we tend to become better investors as we age? This is an increasingly important question as the U.S. investor population is both aging and living longer. Unfortunately, research has found that in general the answer is no, although it’s not all one-sided.

On the positive side, as we age, we tend to have more diversified portfolios, own more asset classes and have higher allocations to international equities. And older investors tend to trade less frequently (that’s a good thing, as the evidence shows a negative correlation between individual investors’ trading activity and their returns). They tend to be less affected by behavioral errors, such as selling winners too soon (the disposition effect) and local bias (the familiarity effect). They also tend to own mutual funds with lower expense ratios—another good thing. These choices reflect greater investment knowledge.

Older Investors Less Effective

However, 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.”

Korniotis and Kumar also found that, while older and experienced investors are more likely to follow rules of thumb that reflect greater investment knowledge, the adverse effects of cognitive aging dominate the positive effects of experience. For example, they found that stock picks tend to lag the market by ever-increasing amounts as we grow older, and they exhibit poor diversification skill.

They noted: “The age-skill relation has an inverted U-shape and, furthermore, the skill deteriorates sharply around the age of 70.” They 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.”

As further evidence of this negative relationship, 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 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.

Experienced financial advisors know that it is common for clients to experience an increase in behavioral issues when they reach an advanced age, issues that can negatively impact the odds of achieving their financial goals.

If nothing else, as we age and our investment horizon shortens, investors exhibit an increasing preference for more conservative assets—our tolerance and capacity for risk tends to fall. We want more certainty. This argues for an increasing exposure to safer bonds and other assets with low correlation to equities. Yet that can be taken to an extreme when an insufficient allocation to equities can increase the odds of running out of money.

Risks For Retirees

In his March 2017 paper, “Risks in Advanced Age,” Michael Guillemette discusses the risks that retirees face and possible solutions to help them overcome behavioral hurdles. He points out that “if financial planners make clients aware of their declining cognitive and financial literacy abilities, they may be more willing to make simplified and satisfactory financial decisions.”

Guillemette highlighted an important issue related to longevity risk: “Wealthy people are living significantly longer than their less wealthy counterparts, creating the need for retirement assets to last for an extended period. Life expectancy for the 10th percentile of household income is 76 years for men and 82 years for women. In comparison, for the 90th percentile of income (which is similar to the clientele of fee-only advisors) life expectancy is 85 years for men and 87 years for women.”

This knowledge can help in the decision to buy longevity annuities as a hedge against outliving your assets, increasing the level of certainty and reducing anxiety.

Guillemette concluded with this important insight: “It is important for financial planners to have plans in place before behavioral biases hinder older clients from reaching their goals.”

Another interesting point I’ve heard from CPAs and financial advisors who work with elderly clients is that, as people age, they tend to feel more strongly about paying less or no income tax. One example is that of an elderly person in the 15% tax bracket buying municipal bonds so he doesn’t have to pay income taxes, despite the fact that taxable bonds could provide a higher after-tax return. Older people tend not even to do the analysis because of the bias against paying taxes.

A second example involves doing Roth conversions between retirement and the start of required minimum distributions (RMDs). This necessitates paying income tax but at a low tax rate, thus avoiding paying higher income taxes once RMDs start. Educating investors about the benefits of tax-centric planning in advance of implementing them can help overcome cognitive biases and show that paying some taxes early can actually reduce taxes over the long term.

Summary

The bottom line is that it’s important for investors and advisors alike to take into account the likelihood that financial decision-making skills will eventually decline, creating the potential for poor decisions.

Thus, plans that address this issue should be put in place before that stage is reached. 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.

It’s important to recognize that there are many important decisions to make as we enter the period when our cognitive skills start to decline—decisions that can have major impacts on the success of a financial plan. Among them are:

  • When to begin taking social security. This is a very complicated issue, and filing at the right time can mean tens of thousands of dollars’ difference over a lifetime. Far too many people fail to consider the longevity insurance benefit of delaying social security payments as long as possible.
  • The ability to take advantage of a lower tax bracket between retirement and when RMDs start to reduce the size of IRAs. Taking income at a low bracket early can lead to avoiding paying tax at a higher bracket later.
  • Proper asset location, holding lower-returning assets (such as bonds) in a traditional IRA while holding higher-returning assets (such as stocks) in a Roth IRA to keep future RMDs as low as possible.
  • Evaluating existing life insurance policies. Is there still a reason to keep an old life insurance policy that was necessary with a young family? That policy still has costs, even when the cash value is paying the premium. The cash value could be redeployed, for example, to fund a long-term care insurance policy.

This commentary originally appeared May 10 on ETF.com

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