A soon to be published study of age-related investor behavior

A forthcoming article in the Review of Economics and Statistics by Alok Kumar of the University of Texas at Austin and George Komiotis of the Federal Reserve says older investors are indeed bad.  According to Kumar and Komiotis, a sharp, progressive deterioration of cognitive abilities that begins for most people around the age of 70 overwhelms the positive effects of superior experience.  The result is ever worsening active management performance.There’s a summary of the article, with useful investment tips, in this past weekend’s Wall Street Journal.

The research has actually been around for a while, and was also written up in the New York Times in 2005.

Aging is an issue

I think that aging is a real issue for investors, although not for the reason–age, per se–that the authors cite.

As we age, we become more susceptible to physical and mental diseases that absorb our time and energy, reducing our ability to concentrate on investments.

But also I  think we all underestimate the intense socialization inherent in modern work, especially white collar jobs.  When we retire, it’s like we’re professional athletes who have just broken ties with the team.  No more three hours a day of physical training, no three hours of practice.   No more big games, teammate pressure to perform, no mental training–concentration, visualization.

The intense atmosphere that we’ve become accustomed to and don’t consciously perceive is gone.  Some of us decide we’d prefer going fishing to continuing to train our brains.  And without the social atmosphere and the associated competition, it’s hard to reach the peak performance we achieved easily before.  In what seems the blink of an eye, we’re like the retired athlete who’s no longer a greyhound, but has gained 50 pounds of unsightly flab.

I’ll come back to this later, but first to the study.

How the study worked

The researchers got a discount broker to give them access to data for 62, 387 customers over six years, from 1991-1996.  They looked only at common stocks and common stock trading.

The average account had 4 stocks in it, with a combined value of $35,629.  The median account had 3 stocks in it, worth $13,869.

The study used zip code data to estimate income, education and ethnicity.  Average income, which didn’t vary much across age groups below 60 was $90,782.  Mean wealth was $268,909.  Therefore, the portfolios studied represented about a third of yearly income and 13% of estimated wealth.

About 27% of the accounts were of California residents.  The study looked at both total and ex-California results, which showed no differences.

The conclusions:

–no one beat the S&P 500

–relative performance by age group rose steadily from twenty-somethings to peak with people in their mid 40s.  Performance began a decline that really accelerated after 70.

–High income, better educated clients did better than average.  Low income, less educated and minority group clients did worse.

Where I think the study goes wrong

1.   A quibble. In any endeavor like this, you study the characteristics of a small group that you then argue is representative of the population as a whole.  In this case, the argument is that the traits of clients of the unnamed discount broker are indicative of investors throughout the US.  We already have reason to suspect that this isn’t true here, since California makes up 12% of the US population but 27% of the accounts studied.

2.  The dollar amount of stocks studied is very small.  More important, although the study’s authors argue that the stocks in question don’t represent “play money” or afterthoughts to the account holders, they have no way, other than information from account applications and zip codes, to determine this.

For younger investors, their main source of wealth is most likely their human capital, that is, their professional skills and educational investment in themselves.  Older investors will likely own real estate, pensions, IRAs or 401Ks or stock (or some other ownership interest) in the company where they work.  I don;t think this has ben factored into the wealth estimates.

3.  Financial information in a client’s initial brokerage application can be seriously out of date. Also, the wealth and income data can be seriously understated.  As any financial advisor will tell you, clients can be very reticent about revealing the true extent of their wealth, for fear they will be pressured to shift assets from elsewhere to the broker in question.

4.  I don’t think conventional risk adjustments address the situation of the older investor.  At some point, an investor’s goal changes from trying to accumulate more wealth to trying to preserve the wealth he has.  Beating the S&P 500 goes out the window and preserving income walks in the front door.

In addition, the more cautious attitude an older investor may have will likely be reinforced if he has a financial advisor.  Besides the client’s financial health, the advisor also has to consider the possibility that he may be sued by the client’s heirs if the investments have gone down in value.  Remember, customers of traditional brokers often have discount brokerage accounts as well, where they do trading based on the “full service” broker’s advice.  Why?  …to avoid the high fees the latter charges, and that the client thinks are out of line with the value of the advice received.

In other words, underperformance vs. the market may be a function of increased risk aversion, not cognitive decline.

What I think is important

I usually don’t like newspaper articles about investing, but I thought the Wall Street Journal one was pretty good.

1.  Simplify your investments, so that you are able monitor them in the time you are willing to devote to this.

2.  Have a backup plan for if you become sick or otherwise unable to spend time on investing–in other words, how do you get from where you are now to total indexing.

3.  Have records that allow you, or some one else, to determine things like cost basis.  Be especially careful if you have (as many people do) brokerage accounts you’ve closed but which contain cost data for stocks you’ve transferred elsewhere.  If you hold actual physical stock certificates, make sure that you have a separate list of what you own, in case the certificates become lost or damaged.