Cognitive Ability and the Stock Reallocations of Retirees during the Great Recession
23 Pages Posted: 5 Feb 2014 Last revised: 7 Nov 2014
Date Written: February 4, 2014
Retirees are increasingly responsible for managing their own retirement savings. The ability to manage these assets efficiently can have an important impact on retirement wellbeing. Lower levels of cognitive ability in old age can reduce an investor’s ability to control emotional responses to a loss. This may result in an increased preference for safety following a market decline, resulting in a reallocation away from stocks that is associated with long-term underperformance. We investigate whether cognitive ability is related to a shift in portfolio allocation among retirees during the 2007-2008 financial crisis using the following conceptual framework, Stock Reallocations=f(cognitive ability, risk tolerance, sentiment, demographics). Using panel data from the Health and Retirement Study to compare return-adjusted asset allocations in 2008 to portfolio allocations in 2006, 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, even after controlling for age, education, and other household characteristics. It is likely that investors with low cognitive ability are more prone to the effects of sentiment that lead to inflows following high recent returns and outflows following a market decline. Our results suggest that retirees with lower cognitive ability may be particularly vulnerable to underperformance resulting from market timing mistakes. Our results may help explain the negative relation between investor performance and advanced age.
Keywords: great recession, cognitive ability, stock reallocation, household finance, retirement
JEL Classification: D12, D81, D91, H31
Suggested Citation: Suggested Citation