Do older people make better investment choices due to their additional years of investment experience or does investment skill deteriorate with age? Does the time eventually arrive when we should modify the types of investments we make or perhaps give up control over our investment decisions to a trusted family member or professional trustee?
Certainly aging brings with it an increasing risk of dementia or other cognitive impairment. But, what about seniors without such obvious impairment – how does aging affect our decision making – and how can we protect ourselves and our portfolios from loss if our skill does eventually decline with age? Although each of us surely ages differently, are their some general conclusions that can be drawn?
This month’s issue of the AAII Journal contains a fascinating interview with David Laibson, professor of economics at Harvard University, on the subject of the impact of aging on investment ability. Aging and Investing: The Risk of Cognitive Impairment, AAII Journal, September 2011 (registration required).
Professor Laibson suggests that there are two categories of intelligence that are critical to investing: “fluid intelligence” – the creative ability to analyze new information and solve novel problems, and “crystallized intelligence” – the ability, through life experience, to accumulate knowledge that helps us solve familiar problems and become better investors.
After we reach age 20, these intelligences start moving in opposite directions. Fluid intelligence begins to decline (before most of us will even have anything to invest) while our crystallized intelligence generally improves with experience and age. During our 50s, the decline in fluid intelligence becomes dominant and our overall ability to make sophisticated decisions begins a gentle decline.
So, for many of us the peak in our ability to make the best investment decisions is during our 50s. By the time we’re in our 80s, our ability to make good decisions is significantly compromised, particularly decisions that involve complicated new problems (like evaluating a financial product with which we are unfamiliar).This is just normal aging.
Of course, all bets are off if an investor develops dementia, such as Alzheimer’s, which impacts every aspect of intelligence. Unfortunately, the risk of dementia doubles every five years that we age. By the time we reach our 80s, the likelihood of having relatively severe dementia is about 20%. The risk of having significant cognitive decline that is not dementia (“cognitive impairment not dementia” or CIND) affects another 30% of people in their 80s. This means, says Professor Laibson, that half of the 80 year old population should not be making important financial decisions.
How Should We Prepare for the Aging of our Investment Ability
Because the risk of eventual cognitive impairment is so great, we need to prepare for it when we are in our 60s (if not sooner). Laibson suggests that everyone should consult an estate planning attorney to discuss and execute several critically important legal documents. On the financial side these documents include a will, a financial power of attorney, and possibly a trust. Your lawyer can also help you create legal authority for appropriate health care decision making in the event your incapacity. Don’t wait until decline sets in to do this legal planning – it involves complicated and subtle decisions that are best made while you are at maximum competency.
Psychological preparation for aging is also crucial. You need to come to terms with the reality that you are probably not going to be operating at a high level of cognitive functioning over your entire life. If your family relationships are good, help prepare your family for this reality as well.
Organize your assets so that you don’t end up being ripped off by con artists, or end up purchasing investments that are inappropriate for you. As your age and your risk of cognitive decline increase you might consider setting up a trust to provide professional management and protection for your investment portfolio. If you continue to invest on your own, recognize that your ability to analyze complicated new financial products declines with age and stay away from them. Stick with less-likely-to-go-awry investments like diversified mutual funds with low fees. With this latter kind of investment you are basically delegating decision making to the mutual fund manager.
Avoid the two big mistakes that many investors make as they age. The first mistake is to think that dementia won’t happen to them. Accept the reality that there is a significant chance that substantial cognitive decline will affect your life someday. The second mistake is thinking that you will recognize cognitive decline when it occurs. “That’s a grave mistake" says Professor Laibson. "We don’t have that ability to suddenly recognize it and do the right thing just before we lose the capacity to make these decisions well.” Don’t wait. Be prepared in advance.
Based on my experience as an elder law attorney, Professor Laibson is providing excellent advice. Every experienced elder law attorney can relate many stories about clients who purchased wildly inappropriate investments they didn’t understand with resulting sad consequences. You can preserve your financial security through acceptance of the realities of aging and cognitive decline and by preparing well in advance. Acceptance and preparation may be the wisest investments of all.
For Further Reading:
Korniotis and Kumar Does Investment Skill Decline due to Cognitive Aging or Improve with Experience? (July 2007). “We find that older and more experienced investors hold less risky portfolios, exhibit stronger preference for diversification, trade less frequently, and exhibit greater propensity for year-end tax-loss selling. And consistent with the psychological evidence, we find that older investors exhibit worse stock selection ability and poor diversification skill. The age-skill relation has an inverted U-shape and, furthermore, the skill deteriorates sharply around the age of 70. Thus, older investors exhibit a greater propensity to use common investing “rules of thumb” but they appear less skillful in successfully implementing those rules.
Agarwal, Driscoll, Gabaix, and Laibson, The Age of Reason: Financial Decisions over the Life-Cycle with Implications for Regulation (October 2009).
Mark Miller, How To Protect Assets From Risk of Cognitive Decline (August 2011).
To find an expert Estate Planning Attorney who is familiar with the issues of aging you can look for a Certified Elder Law Attorney. If you live in Pennsylvania, you can contact one of the offices of Marshall, Parker and Associates which has 5 Certified Elder Law Attorneys on staff. Offices are located in Williamsport, Wilkes-Barre, Scranton, and Jersey Shore (phone 1-800-401-4552). If you reside in another state, you can locate a Certified Elder Law Attorney in your geographic area by visiting the website of the National Elder Law Foundation.