Are Seasoned Investors Better?

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Seasoned Investors

At least one asset is guaranteed to enrich your portfolio this year: your investing experience. Stick at it long enough and you will encounter practically everything from start-ups to meltdowns, flashes in the pan to flash crashes, 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. Older investors appear to make better sense of disparate incoming information, typically by making fast and frugal references to well-learned patterns from the past. 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.

The finance literature praises the ‘efficient’ decision-making skills of experienced investors, but seemingly ignores many of the other important changes they undergo as they get older

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 disposition effect. This psychological observation refers to the tendency of investors to hastily liquidate their profitable investments, while allowing their loss-making holdings to fester, often unattended. This is not to say that trained investors are immune to this trait. Research has demonstrated that even professional fund managers exhibit the disposition effect, and that this behaviour is detrimental to their performance – the securities 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.

One conflicting piece of evidence about the investing benefits of getting older comes from data revealing that the performance of youthful fund managers is superior to that of 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 judiciously taking less risk). 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 greying individual investors; notwithstanding some career-related incentives, these fund managers might have become smarter with age.

The finance literature praises the ‘efficient’ decision-making skills of experienced investors, but seemingly ignores many of the other important changes they undergo as they get older. Even as one gains in investing expertise, diminishing cognitive skills because of advancing age might make one less able to put this expertise into practice. For example, to recognise patterns in incoming news flow, one must be able to attend to multiple streams of data simultaneously, to remember when such patterns previously occurred, and to recall the all-important investing rules.  All of these abilities, however, tend to degrade with advancing age.

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 inversion in this curve might only really hurt our investing skills by 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, it is more easily able to outweigh the continued accumulation of investing wisdom.

What then should investors do when faced with the prospect of going ‘over the hill’, or if they are already on the wrong side? Well, to stop investing would be the wrong response.  Even though we might cease becoming better investors at some point in our lives, that point will likely be reached many years, perhaps even decades before the end. One should instead seek to attenuate and compensate for the adverse effects. For example, one should try to slow cognitive aging by remaining engaged in intellectually stimulating activitiesOne must also be prepared to seek advice. 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 a second opinion, but they should seek it all the same. Compensating for aging also means reserving more time to make investment decisions to allow for 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 that final piece of advice.

 [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.

By Herman Brodie, Prospecta Limited

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