At least one asset is guaranteed to enrich your portfolio this year: your investing experience. Stick at it long enough and, as an investor, you will encounter practically everything from start-ups to meltdowns, flash crashes to flashes in the pan, slim pickings to fat fingers. You will also discover the financial impact of earthquakes and tsunamis, of both the political and geological varieties. The wisdom of the years, one might argue, ought to make you a better investor.
Empirical evidence reassuringly supports this hypothesis, with one important caveat – it is investing years that matter, not chronological. Veteran investors appear to make better sense of disparate incoming information, typically by making fast and frugal references to well-learned patterns from the past stored in their memory. They also appear to have a better understanding of risk and reward. Consequently, they tend to exhibit lower levels of overconfidence, are less likely to gamble in the stock market, and are likely to hold more diversified portfolios than younger investors.
In terms of investors’ emotional tolerance for risk, experience also brings tangible advantages. With growing experience comes greater financial sophistication, which, other things being equal, tends to decrease investors’ anxiety about holding risky assets. If one can tolerate a permanently higher level of portfolio risk without periodically falling prey to bouts of anxiety, sleepless nights or panic, then, over the long-run, one ought to be able to earn higher returns.
Seasoned investors also differ from their less-experienced peers in another important respect: they are less likely to be prone to the #DispositionEffect. This psychological observation refers to the tendency investors have to hastily liquidate their profitable investments, while allowing their loss-making holdings to fester, often unattended, in their portfolios. This is not to say that seasoned investors are immune to this trait. Research has demonstrated that even professional fund managers exhibit the disposition effect, and that the tendency harms their performance – frequently, the stocks they sell subsequently outperform the ones they hold. Nonetheless, as the disposition effect is probably the single greatest behavioural hurdle for long-run investing success, any reduction that comes with age is welcome.
No advantages to being young?
One conflicting piece of evidence about the investing benefits of getting older comes from data revealing that youthful fund managers have higher performance than their older peers. However, here too, we must make a distinction between chronological age and years of experience. If one isolates those professional fund managers with the longest tenures, i.e., those who have been doing the job the longest, irrespective of age, we note that these are also the ones who tend to have the highest risk-adjusted returns (typically achieved by taking less risk while maintaining satisfactory performance). One must also remember that, unlike individual investors, fund managers’ investment horizon is that of their clients, and this remains unchanged even as the manager gets older. So, their changing behaviour is not due to the typical risk-aversion one observes among individual investors as they progress along the life cycle; notwithstanding some career-related incentives, these fund managers might actually have become smarter with age.
The finance literature lauds the ‘efficient’ decision-making skills of experienced investors, but does so by systematically ignoring many of the other important changes we undergo as we get older. To recognise patterns in disparate information supposes that one can still manage to attend to multiple streams of incoming information simultaneously, to remember when such patterns previously occurred, and to recall the all-important investing rules. Yet, all these abilities tend to degrade with advancing age. Thus, even as we gain in investing expertise, diminishing cognitive skills because of advancing age might make us less able to put these skills into practice.
Going over the hill
On a graphic, with chronological age on the horizontal axis, a plot of investment decision-making skill would appear as an inverted u-shape. The curve for investors with more years of market experience would be higher than for those with less, but all would suffer the almost inevitable decline as the curve moves to the right, due to the age-related deterioration of memory, attention, and information processing speed[1]. The only consolation for most of us is that the peak in this curve might only be reached in our 70th year. The decline in cognitive abilities, although it begins in one’s fifties, tends to become much steeper after the age of seventy. By then, is it able to outweigh the continued accumulation of investing wisdom.
So what should investors do when faced with the prospect of going ‘over the hill’ in this theoretical context, or if they are already on the wrong side? Well, to stop investing would be the wrong response. Even though we might stop becoming better investors at some point in our lives, that point will likely be reached many years, perhaps even decades before the end. One must, however, recognise and accept the known constraints that come with aging, and seek to attenuate and compensate for them. For example, one should try to slow the adverse effects of cognitive aging by remaining engaged in intellectually stimulating activities throughout one’s life. One must also be prepared to seek advice and second opinions of one’s evaluations.
I should add here that although financial decision-making abilities decline with age, confidence in those abilities usually does not (especially among men). So investors might not want, or feel they need that second opinion, but they should seek it all the same. Compensating for aging also means allowing more time to make investment decisions in order to accommodate slower information processing speeds; gathering all the pertinent information together in one place to reduce the reliance on attention and memory; and following a structured, check-list approach to the decision process to avoid straying from the tried and tested rules of investing. All investors, young and old, could benefit from following that final piece of advice.
Herman Brodie. Prospecta Limited
First published by TCAM Asset Management Ltd
References
Blanco, Nathaniel J.; Love, Bradley C.; Ramscar, Michael; Otto, A. Ross; Smayda, Kirsten; Maddox, W. Todd (2016) Exploratory decision-making as a function of lifelong experience, not cognitive decline. Journal of Experimental Psychology: General, Vol 145(3), Mar 2016, 284-297
Chevalier, Judith, and Glenn Ellison, (1999) Are Some Mutual Fund Managers Better than Others? Cross-Sectional Patterns in Behavior and Performance.” Journal of Finance, vol. 54, no. 3 :875–899.
Dhar, Ravi & Zhu, Ning (2006) Up Close and Personal: Investor Sophistication and the Disposition Effect. Management Science, May 2006, 726 - 740
Finke, M.S., Howe, J.S., & Huston, S.J. (2016) Old Age and the Decline in Financial Literacy
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James BD, Boyle PA, Yu L, Han SD, Bennett DA (2015) Cognitive Decline Is Associated with Risk Aversion and Temporal Discounting in Older Adults without Dementia. PLoS ONE 10(4)
George M. Korniotis & Alok Kumar (2011) Do Older Investors Make Better Investment Decisions? The Review of Economics & Statistics, February 2011, Vol. 93, No. 1, 244-265
[1] Some of the reported decline in information processing speed among older individuals is due to the knowledge effect. As one accumulates knowledge over the years, one’s mental database might become unwieldy. For instance, sifting through one’s brain to find an optimal investment strategy is more time-consuming if one has a hundred potential strategies in memory than if one has only ten.