Making Lemons into Lemonade

There is an increasing body of work suggesting that cognitive ability declines in old age, especially after age 70. In fact, several researchers suggest that financial decisions are made most astutely when an individual is in her or his mid-40s to 50s.

George M. Korniotis and Alok Kumar,

from the University Of Miami School Of Business Administration tackled this pertinent question recently: “Will cognitive aging overcome the positive effect of experience and thereby result in older investor’s portfolios underperforming common performance benchmarks?”

Their premise was, “Although older investors would accumulate greater knowledge about the fundamental principles of investing from their investment experience, their declining cognitive ability could hinder the effective application of those principles.” The authors summarized their work and that of others in a chapter entitled, “

. “ It was published in

BEHAVIORAL FINANCE

Korniotis and Kumar report both bad and good news, the lemons and the lemonade. The former is that the ability to make financial decisions is reduced in old age. The latter is that some individuals are more exempt from this fate than others.

The sum and summary of the numerous studies cited is that individuals with high cognitive ability are more likely to participate in the stock market. This is generally positive as this invested money is more likely to stay even or outpace inflation. When participating, though, different investment decisions are made by subgroups of individuals. For example, those divided according to age, intelligence, income and education. In general, investment skill declines with age. But participants in the studies who had a higher intelligence, education and income showed this effect less.

One issue that the authors point out is that privatizing the social security system — mentioned several times in the past — might be a monumental error. Those citizens who are least able to protect themselves would be most penalized. This is because their study shows that low cognitive abilities were associated with poor investment choices when a portfolio did not follow prescriptive patterns.

In sum and summary, Korniotis and Kumar indicate that those who have been fortunate most of their lives in the areas of intelligence, education and income make better investment choices during aging, at least under certain circumstances. It is those in the “less so,” categories that are more likely to need intervention and care.

Cognitive Abilities and Financial Decisions H. Kent Baker and John Nofsinger (eds.) , Hoboken, NJ: John Wiley & Sons, Inc., 2010. For further reading