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Dispatches

Declining Cognitive Skills Associated With Overconfidence

A analysis of data collected in a study on cognitive abilities in older adults found a positive association of unjustified confidence with risky investments in those with declining cognitive skills.

by AAII Staff | December 2016

Investors with declining cognitive skills tend to have higher levels of confidence in their financial skills. This overconfidence leads to a larger allocation to equity investments and a smaller allocation to cash.

Authors of a study accepted for publication in the Journal of Behavioral and Experimental Finance reached this conclusion after analyzing data from the Cognitive Economics Study (CogEcon). The CogEcon study tracks Americans age 50 and older to evaluate their cognitive abilities. CogEcon stands out among studies of its type by asking respondents how certain they are of answering questions about financial sophistication correctly.

To determine whether a link between declining cognitive abilities and overconfidence skills exist, Tae-Young Pak and Swarn Chatterjee looked at the financial statements as well as the CogEcon financial sophistication and confidence scores. What they found was a “positive association of unjustified confidence with risky investments.” CogEcon participants whose confidence levels were higher than their test scores were found to have a greater allocation to stocks and stock funds. The authors further concluded that an “age-related increase in overconfidence makes people stay longer in the equity market while keeping fewer cash reserves.”

Pak and Chatterjee say the magnitude of the link between aging-induced overconfidence and portfolio allocation is “likely to be larger than our estimates” if a longer period and more exhaustive information is used. They acknowledge, however, that their study does not take into account the impact of transitioning control of the portfolio decisions to another member of the household, such as a spouse, or the resistance to such an idea. They also suggest that further research should be done, given that their time period included the years immediately following the 2008 financial crisis.

The study is noteworthy because overconfidence has been shown to lead to poorer portfolio outcomes, as discussed in “Trading More Frequently Leads to Worse Returns” (November 2014 AAII Journal). Furthermore, links have been found between declines in cognitive skills and financial problems, as explained in “Dementia and Financial Decision Making” (September 2013 AAII Journal).

Source: “Aging, Overconfidence and Portfolio Choice,” Tae-Young Pak and Swarn Chatterjee, Journal of Behavioral and Experimental Finance, October 4, 2016.

Discussion

Karyl Magee from VA posted over 9 years ago:

I wonder if they have considered the "desperation factor" involved here whereby seniors have been literally forced into fully loading up their savings accounts in the higher risk high yield investment products as a result of the last financial crash and ensuing 8 years of ZIRP and a government policy that has resulted in a restriction on economic growth for the last 8 years. When you listen to radio call-in programs to financial professionals, a large number of the callers are retirees trying to find a way to live off of their savings while making them last through out their retired lifetimes. They have to invest it high yield to keep their bills paid in many cases, as bonds crash and banks offer 0.01% interest. I am sure there are cases where once active and successful traders have succumbed to dementia with disasterous results, thinking that they still have the magic touch, but I have also heard of many cases where successful investors have kept their minds clear by daily active use while pursuing a retiree life of research, trading and investing.


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