Fund Indexers, Take (Another) Bow

[Bylo Selhi]

Fund Indexers, Take (Another) Bow [WSJ, 04Dec05] [If link is dead, search Archive for "clements", then select Dec 04 article]

Again and again in this column, I have argued that most stock-mutual-fund investors won't earn market-beating returns and that these folks would be better off buying market-tracking index funds. It turns out, however, that your chances of outpacing the stock-market averages are far slimmer than even I imagined.

What's the problem? Most performance-hungry investors don't own just one actively managed fund. Rather, they own a whole fistful of funds -- and with every fund they add, the odds against them grow steeper...

[Bylo Selhi]

And the older you are, the more reason you have to index

Aging Brings Wisdom, but Not on Investing [NYTimes, 04Dec05]

DO people generally become better investors as they age? Unfortunately, new research has found that the answer is no...

As people grow older, their cognitive ability tends to diminish - a gradual decline that presumably affects decision-making in all facets of life. In investing, the researchers concluded, it makes older people less capable of picking market-beating stocks. The net result - at least for those who trade individual stocks of their own choosing - is that overall investment performance declines steadily with age...

Because every age group in their study trailed the market, the researchers believe that all investors should favor index funds, which mirror the performance of the market and don't attempt to beat it. This advice becomes increasingly important as investors grow older...

[Chuck]

They found that the average 65-year-old investor's stock picks lagged behind those of the average 30-year-old investor's by 1.8 percent a year. The overall effect of the aging process was for 65-year-olds to have an average annual return about 1.1 percent lower than the typical 30-year-old's.

Hmmm...did they adjust for risk? I'm thinking the average 30 year old invests in a lot more 'high growth' and/or small cap companies than the average 65 year old. I'm thinking I will be all about blue chip large cap dividend payers when I am 65. If I give up a little growth, so be it.

Sounds to me the like 'high cognitive ability' number crunchers could use a little wisdom themselves.

[novice]

Good point Chuck. As one of those old farts with a bias toward blue chip dividend payers, I also thought any underperformance in grandpa’s investments might be more readily explained by shifts to a less risky portfolio later in life. However, I downloaded the original Korniotis and Kumar (2005) article, and discovered that they used multiple regression procedures to statistically control individual differences in portfolio risk prior to extracting the effects of age on the several measures of investment performance they used. So, their general conclusion that investment skills tend to decline with age is based on risk adjusted data.

There were, however, a couple of other problems with the study that did worry me. The sample consisted of ~62000 households with discount brokerage accounts. The average number of stocks in a portfolio was 4 (median 3), the average portfolio size was about 36K (median 13K), and the average account had been in place for about 10 years. These stats lead me to suspect that these discount accounts perhaps represent “play” money for the older investors in their sample. The more serious money required for income in retirement may be located (for better or worse!) in full service brokerage accounts. If so, the message of the NY Times article should be “ old farts are more likely to be burned if they play around with their money.”

The other concern is that the effect sizes in this study are very small. At best, age, as a predictor variable, tends to explain only ~2 percent of the variance in the investment performance measures (i.e. a correlation of .15). Although this is a statistically significant in this very large sample, it is not a very impressive association in real world terms. Of course I don’t doubt that, at some point, creeping senility will take its toll. But from my perspective, these numbers are actually somewhat encouraging!

Finally, I suspect that some of the financial advisors on this forum might find this article worth reading. The authors’ overview of the relevant literature provides some interesting tidbits describing changes investor preferences and behavior as they age. I did not realize, for example, that the disposition effect often observed in behavioral finance research apparently declines with age, and the asset allocation decisions of the elderly are more biased toward equities than I would have suspected.

Thanks for the Times link Bylo.

N