Do older investors earn higher returns than younger investors? Intuitively, you may have thought so, given their greater experience and wisdom. But, as LARRY SWEDROE explains, the academic evidence suggests otherwise.
— Daniel Kahneman, Nobel Laureate in Economics
As a young tennis player, I was often frustrated when I played against much older men. The reason was that while my athletic prowess was superior (I was faster, quicker, stronger and could hit the ball harder), they would often beat me, and beat me badly. They would move me around the court, hitting drop shots, lobs and shots with lots of spin. Eventually, I would make a mistake. Trying to hit a powerful shot, I would hit the ball long, wide or into the net. Those matches taught me that experience, and the wisdom that comes from it, can triumph over youth and vigour.
The population of the United States is rapidly ageing. The ageing population, along with the failure of Congress to address the shortfalls in funding for social security and health care programs (Medicare and Medicaid) has created a deficit in those programs estimated to be as much as $80 trillion. Thus, it is likely retirees will have to depend on their investments even more than expected to provide a significant portion of their income. This raises lots of questions, including whether older investors make smarter investment decisions.
There’s an old adage that with age comes wisdom. But do we tend to become better investors as we age? Unfortunately, research has found that, in general, the answer is no, older investors are no better than younger investors, although it’s not all one-sided. Two conflicting forces might be at work: the wisdom older investors gain from their experiences, and the possibility of diminishing cognitive abilities. We’ll review the research findings.
Research findings
George Korniotis and Alok Kumar, authors of the study Does Investment Skill Decline Due to Cognitive Ageing or Improve With Experience? examined the portfolios of more than 75,000 self-directed individual investor accounts at a large U.S. brokerage firm for the period 1991-96. Because the accounts were self-directed, the assumption was that the individuals were making their own investment decisions. While there was some good news, the results were not encouraging. Let’s review the good news first.
As investors age, they appear to learn from their experiences. Older investors:
Trade less. The evidence, from studies such as the 2000 paper Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors, has demonstrated that the more investors trade, the worse the results. Thus, less trading improves returns.
Diversify more. They tend to hold more securities, avoiding the all-the-eggs-in-one-basket-type bets younger investors are prone to make. Diversification reduces unsystematic risk (risk unique to single stocks or sectors) for which investors receive no compensation (no higher expected returns). Diversification also reduces volatility and the risk of severe losses, and results in less risky, more efficient portfolios. The authors also found that investors who have a preference for more stocks also hold more mutual funds (further diversifying their portfolios).
Buy less risky securities. Within each asset class, older investors prefer less risky securities, appropriate to their shorter investment horizons and reduced ability to take risk. Risk was measured by volatility, skewness (a measure of the asymmetry of a distribution) and kurtosis (the degree to which exceptional values, much larger/smaller than the average, occur more/less frequently than in a normal distribution). By avoiding stocks with high degrees of skewness and kurtosis, they take less risk of extreme outcomes—in an attempt to avoid severe losses, they don’t chase extreme positive returns. Older investors also own fewer small-cap stocks, initial public offerings (IPOs) and very low-priced stocks (lottery-type stocks)—all riskier securities.
Have a greater propensity to harvest losses. For taxable accounts, whenever losses are significant, they should be harvested for tax purposes. Younger investors are more prone to the psychological problem known as “myopic loss aversion”—by selling, they are admitting a “mistake” and are reluctant to do so. Thus, they miss out on the tax benefits older investors take advantage of.
Unfortunately, it seems investors don’t age as well as tennis players. But the bad news outweighs the good. Older investors:
Exhibited deteriorating stock-selection skills.
The age-skill relation has an inverted U-shape, with skill deteriorating sharply around the age of 70.
The average 65-year-old’s stock picks lagged behind those of the average 39-year-old by almost 2 percent a year.
Stock picks tend to lag the market by ever-increasing numbers as we age, and older investors exhibit poor diversification skill.
On average, investors with stronger ageing effects earn about 3 percent lower risk-adjusted annual returns, and the performance differential is over 5 percent among older investors with large portfolios.
Fail to effectively diversify. While an increase in the number of stocks owned reduces risk, the effectiveness of diversification is dependent on the covariance (or correlation) of the stocks in the portfolio. Even though older investors owned a greater number of stocks, they exhibited poor diversification skills in their selections. The net result was that older investors underperformed their younger peers by about 2 percent a year on a risk-adjusted basis. Making matters worse, all age groups underperformed the market.
Are less effective at applying investment knowledge and exhibit worse investment skill. This is especially true if they are less educated, earn lower income, and belong to minority racial/ethnic groups.
Korniotis and Kumar concluded: “Our hope is that older people would recognize the adverse effects of cognitive ageing and would try to compensate for those effects, perhaps by seeking advice from a financial adviser or some other qualified investment professional.” The research demonstrates that most investors would benefit from such advice.
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 published in the January 2017 issue of Management Science, 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. This led them to conclude that increasing confidence and reduced abilities explain poor investment (and credit) choices by older investors—age is positively related to financial overconfidence, which can be a deadly sin when it comes to investing. Adding to the problem is the tendency for older investors to reject evidence of declining cognitive abilities.
Experienced financial advisers know it is common for clients of advanced age to experience an increase in behavioral issues that can negatively impact the odds of achieving their financial goals. If nothing else, as they age and their investment horizon shortens, investors exhibit an increasing preference for more conservative assets—their tolerance and capacity for risk tends to fall. They 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.
In his March 2017 paper Risks in Advanced Age, Michael Guillemette discussed the risks retirees face and possible solutions to help them overcome behavioral hurdles. He pointed 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 advisers) life expectancy is 85 years for men and 87 years for women.”
Another interesting point I’ve heard from CPAs and financial advisers 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-percent 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 tax 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.
One more important point to cover is the risk of elder abuse.
Elder abuse
Unfortunately, a decline in mental sharpness is inevitable for many, making them vulnerable to financial abuse. At least a third of us who reach age 85 will develop Alzheimer’s disease. Alzheimer’s victims lose financial capacity fairly early in the disease process. But even if you do not suffer any decline in mental sharpness, there is no guarantee you will be untouched by those seeking to take your assets. Very determined professional thieves in our midst have figured out that many seniors have a nest egg that can be stolen.
According to the The True Link Financial Report on Financial Elder Abuse 2015, the amount stolen from elders each year in the U.S. is more than $36 billion. This includes not only outright theft by unscrupulous people in their lives and online predators who are after them, but also other kinds of more subtle abuse. Research demonstrates that no one is completely immune from financial manipulation, regardless of their education, sophistication or experience in financial matters. True Link found that a significant number of victims are younger seniors, college educated, and not living in isolation — and they lost more to abuse than those who were older, less educated, and isolated.
Taking advantage of seniors is not limited to shadowy figures on the internet. However, seniors are especially targets to them. Unfortunately, a painful truth is that family members are the most frequent abusers of seniors. Starting from a position of trust, they see opportunity—the older person might not be as astute as he once was and thus might not perceive what is happening. Or it’s a widow who has assets, and her unscrupulous son, daughter or other relative decides he needs some of that money. He asks for a “loan” to tide him over for a bit, or to start a business, or to take advantage of a “wonderful investment opportunity.”The loan never gets paid back, the business fails, and the investment opportunity is a scam. And the elder often has no recourse.
Fortunately, good estate planning can protect the elderly from such abuse. Have you sat down with an estate planning attorney with a background in elder abuse issues? My book, co-authored with Kevin Grogan, Your Complete Guide to a Successful and Secure Retirement, has a detailed chapter on elder abuse issues and how you can protect yourself. Elder abuse expert Carolyn Rosenblatt co-authored the chapter.
The moral of the tale
All investors would be better off if they stopped trying to outperform the market and simply captured market returns by investing in index funds or other passively managed funds. This advice becomes even more important the older the investor.
The bottom line is that it’s important for older investors and their advisers 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 reaching that stage. They should include granting powers of attorney to trusted family members or professionals for financial and health care matters. And these documents should be reviewed on a regular basis to ensure 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 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 prevent 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 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.