This article was originally published in July 2013 in the Tacoma News Tribune. It has ongoing relevance and was an important part of a recent discussion so I decided to post it here.
By Gary Brooks, CFP®
Successful investors spend years saving their way to a retirement nest egg to supplement Social Security and support a vibrant retirement. Ideally, the accumulated savings will grow through the magic of compounding allowing them to achieve long-term financial security.
But in retirement, the heavy lifting done by personal savings stops and spending starts. Investment decisions become more critical to support withdrawals from accounts over potentially decades of retirement. Unfortunately, this is roughly the same time frame where cognitive skills and ability to reason with numbers begin to erode. As people age, analytical skill declines naturally and inevitably. It does not require a stroke or dementia, for example, for your cognitive ability to slide.
Like other issues associated with aging, the rate of this decline is different for each of us. Research particularly focused on financial decision-making has shown a generally diminished capacity to make prudent money decisions even relatively early in retirement.
Studies by University of Miami professors George Korniotis and Alok Kumar determined that risk-adjusted investment returns decline in the senior years. They found that investors over 70 underperform by approximately 2 percent annually compared with younger investors, controlling for factors of similarity in their respective portfolios.
Investment decisions require processing knowledge (often statistical), inputting experience and reasoning. These are elements of fluid intelligence, which fades over time. Alternatively, crystallized intelligence does not fade (i.e., people can recall synonyms or antonyms without difficulty and, in fact, continue to improve with age in some cases).
What complicates matters is that, according to research out of Texas Tech, confidence in financial decision-making abilities does not diminish as one ages. Confidence in financial knowledge and decision-making stays consistent or even grows over time as longer-term experience is assumed to be valuable. People in their 80s believe their financial knowledge is slightly higher than people in their 60s. And, as their financial literacy fades with advanced age, their confidence does not. This can potentially set people up to make bad decisions around even legitimate investments, and possibly make them more susceptible to fraud and schemes.
“Trouble arises when individuals rely too heavily on their experience in making automatic decisions,” writes Michael Mauboussin in his-thought-provoking book “The Success Equation,” which focuses on recognizing the difference between skill and luck. “When we age, we tend to avoid exerting too much cognitive effort and deliberating extensively over a decision that needs to be made. We gradually come to rely more on rules of thumb. This means that we make poorer choices in environments that are complex and unstable.”
The investment world certainly qualifies as a complex system where skill and luck are often indistinguishable, especially over short time periods.
In my experience, as people move into retirement, they become less interested in performing the due diligence required to stay current with investment options and market conditions. In the most successful retirement scenarios, the lack of interest is matched by a lack of time. One of my favorite expressions of the newly retired is when they state, “I’m so busy I don’t know how I ever had time to work.”
Without time or interest to stay on top of the shifting economic landscape and how it relates to investments and personal goals, people fall back on default decisions.
“The main problem remains that people use their intuition in situations where they shouldn’t,” Mauboussin writes. “(Investing is) a field where training your intuition is virtually impossible because the conditions change too much.”
Don’t leave it to luck
Given this continually changing environment, how would a financial adviser handle this? Apply a process.
Good financial advisers navigate the challenges by working from a data-driven, consistently applied process. A structure that utilizes an investment strategy aligned with a goal, or in most cases, a series of goals which require planning, money and time to accomplish. This is much different than buying and selling from a collection of investments based on intuition and good ideas for the time.
Trust in a sound process and planning for “what if” becomes very important. This is the best way to integrate investment and spending decisions well as considerations about powers of attorney and other legal matters that increase in importance with age.
Proactively address these considerations with a documented process and strategy and you will be more prepared to respond to complex decisions such as how to invest in the challenging markets we face today.
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