None of us is getting any younger – a fact which matters a lot for financial planning.
This is simply because many of us suffer a decline in our mental faculties as we age. In a new paper, Fabrizio Mazzonna and Franco Peracchi studied thousands of Americans aged between 50 and 80 and found that those who were unaware of their cognitive decline (as measured by memory tests) were significantly less wealthy than those who were aware of it or who hadn’t suffered such decline. This, they say, is because such people are “more likely to make bad financial decisions which negatively affect their wealth.”
We know that overconfidence is an expensive error even among younger investors. It’s also a problem for those unaware of their fading powers.
This corroborates earlier research. Harvard University’s Xavier Gabaix and colleagues have shown that we make more mistakes with our money after our mid-50s. And George Korniotis and Alok Kumar at the University of Miami have found that “investment skill deteriorates with age.” This is because although older investors tend to use better rules of thumb (such as “run your winners”) they also worse at picking stocks.
The issue here is not merely the curse of dementia. Some cognitive skills such as short-term memory or the ability to process information begin to decline quite early in adult life. For many of us, this decline is offset by the learning and wisdom that come with age. There comes a point, however, when the latter no longer outweighs the latter.
This did not used to be so big a problem. We used to retire on big final salary pensions or at least be able to buy annuities at decent rates. We didn’t therefore need so much to manage our own savings. Today, however, we do. Which means that we face huge investment risks at a time when our ability to manage those risks is fading.
What can we do about this? We could delegate our wealth management to others. But this runs into problems. Finding a good financial advisor is tricky for anybody, and requires skills such as judgment of character which themselves deteriorate with age: there’s a reason why fraudsters target older people. And as for entrusting the job to family members, well you’ve seen King Lear.
Those of us facing the prospect of cognitive decline – your correspondent is almost 57 – have, however, another solution this this problem. We should simplify our portfolios.
A portfolio comprising merely a global equity tracker fund, a government bond tracker and cash will do most of what you need; equities give us hope of growth, while bonds and cash protect us from downside risk.
You might object that this won’t give you much income and that you need higher-yielding assets for this.
Wrong. The dividend cuts we’ve seen this year on banks and oil stocks (among others) remind us that a high yield is often a sign of high risk. You can instead create your own income simply by selling a portion of your portfolio each year.
In fact, doing this and rebalancing between equities and safe assets – buying more of the latter when prices are lower – is the only trade you need to make each year.
Such an austere strategy of course means that we’ll miss out on some good investment opportunities. But we mustn’t overstate these. The only proven strategies for beating the market are momentum and defensive stocks. Anything else is quite likely to fail sometime.
Which brings us to another change which those of us in or approaching cognitive decline must make. We should worry less about looking for the best investments and instead do what the Nobel laureate Herbert Simon recommended. We should “satisfice” – adopt strategies which while not optimal are good enough. A simple mix of tracker funds does just this. Sure, we lose the chance of beating the market. But we also lose the chance of underperforming. That’s not nothing. Even at the peak of their powers, active investors are prone to many mistakes: hanging onto losing stocks; trading on information that’s already in the price; backing overpriced speculative stocks; trading too much; or buying funds whose managers are lucky rather than skilful. Tracker funds protect us from all these errors.
What’s more, satisficing portfolios protect us from the fact that optimal portfolios can be fragile: investment banks had optimal portfolios of mortgage derivatives in 2007 – but what was optimal in a low-volatility environment turned out to be lethal when that environment changed.
In one sense, all this is in fact elementary economics. Lionel Robbins famously defined economics as “the science which studies human behaviour as a relationship between ends and scarce means.” Cognitive ability is scarce, and getting scarcer for some of us. We should economise on it.
