Cognitive Ability and the Stock Reallocations of Retirees during the Great Recession

Abstract

Retirees are increasingly responsible for managing their retirement savings. The ability to manage these assets efficiently can have an important impact on retirement well-being. Lower levels of cognitive ability in old age can reduce an investor's ability to control emotional responses to a loss. Greater sensitivity to loss may increase preferences for safety following a market decline, resulting in allocations away from stocks that are associated with long-term underperformance. We investigate whether cognitive ability is related to stock reallocations among retirees during the Great Recession. Using the Health and Retirement Study, we find that cognitive ability is negatively related to allocations away from stock. Compared to those with the lowest levels of cognitive ability, respondents with higher cognitive ability are 40% less likely to reduce their stock allocation by 50% or more. These results suggest that the quality of investment decisions in old age may be compromised by cognitive decline.Retirees are increasingly responsible for managing their own retirement savings. The shift from defined benefit (DB) to defined contribution plans in the United States transfers the burden of asset management from professionals to individual investors. The ability to manage these assets efficiently can have an important impact on retirement well-being.Studies of investor behavior in mutual funds show that individual investors underperform the market by about 150 basis points annually, mainly because they sell stock funds during a bear market (Friesen and Sapp 2007). This tendency to shift investment portfolios away from equities following a price decline is opposite to what would be expected through optimal rebalancing. The most commonly used model to explain investor trading and allocation decisions is the mean-variance model (Markowitz 1952). Under modern portfolio theory, portfolio allocations between the risky and riskless asset are based on the investor's risk tolerance. Because investors have stable risk preferences and incorporate all available historical data when forming beliefs about risky outcomes, they will select an optimal portfolio that is unaffected by short-run market performance.

Why are older investors less willing to take financial risks?

“…Rypma et al (2001) show that the information processing power of the prefrontal cortex declines as individuals age, leading experiences and emotions to have an increased role in decision-making. This possibly reduces psychological resilience to investment losses and leads to a heightened tendency to sell risky assets at their lowest points following heavy losses (Browning and Finke, 2015), which causes an average potential return loss of 1.6% per year (Friesen and Sapp, 2007). A reduced capacity to determine and limit risks may encourage older investors to avoid taking such risks in the first place (Yao et al, 2011).…”

Understanding the Correlation between Alzheimer’s Disease Polygenic Risk, Wealth, and the Composition of Wealth Holdings

“…Extant literature has documented the relation between cognitive ability and behavioral biases (Benjamin, Brown, and Shaprio 2013;Dohmen et al 2010;Frederick 2005), and financial decisions and outcomes (Agarwal and Mazumder 2013;Christelis, Jappelli, and Padual 2010;Grinblatt, Keloharju, and Linnainmaa 2011;McArdle, Smith, and Willis 2009). Individuals with better cognitive ability make fewer mistakes when they invest (Agarwal and Mazumder 2013), are more likely to hold any stocks (Christelis et al 2010;Cole, Paulson, and Shastry 2014;Grinblatt et al 2011), allocate more assets in stocks (Browning and Finke 2015), and earn greater risk-adjusted returns (Grinblatt, Keloharju, and Linnainmaa 2012).…”

What I Know, What I Think I Know, and Whom I Know

“…Extant research finds that objective financial knowledge is positively related to subjective financial knowledge (Hadar, Sood, and Fox ; Raju, Lonial, and Glynn Mangold ; Tang and Baker ; Wang ). Since objective financial knowledge is related to an individual's cognitive ability on a knowledge domain (Browning and Finke ), it may allow individuals to understand difficult investment information quickly and to analytically examine different investment options by applying decision criteria available from memory before making an investment decision (Alba and Hutchinson ; Hadar, Sood, and Fox ). Therefore, individuals who have a high level of objective financial knowledge may increase their self‐assessment of knowing and in information processing (Raju, Lonial, and Glynn Mangold ; Wang ).…”

“…401(k) account holders' investments in risky assets may be influenced not only by their objective financial knowledge but also by their financial knowledge networks. Because objective financial knowledge can elevate cognitive ability (Browning and Finke ), it may enable individuals to identify risky assets with higher returns and reduce information search and process costs in investment decisions. An investment decision or managing a portfolio usually requires an investor's significant time, effort, and ability to understand asset returns, volatility, covariance between assets returns, and transaction costs (Christelis, Jappelli, and Padula ).…”