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Our investment thinking changes as we get older

It’s well known that human beings are loss averse. By this is meant that, if (as an example) we’re given a 50/50 chance of winning or losing some specific amount (let’s say $500) based on a heads-or-tails toss of a coin, we tend not to want to play. Unless, of course, the amount is small (let’s say $10), and the sheer thrill of playing is worth it, even if we lose – in other words, we’re willing to pay to buy the thrill; but as a serious investment proposition, no.

What we tend to want, in an example such as this, is that the game is biased in our favour: perhaps $500 either way, but with the odds favouring us, say a 70% chance of winning versus only a 30% chance of losing; or, if the odds stay at 50/50, then a win is worth $700 versus a loss costing us only $300.

This attitude of loss aversion has been documented through countless research studies, and it is one of the main conclusions of the brilliant research (now known as 'prospect theory') done by Nobel Prize winner Dr Daniel Kahneman and his research partner Dr Amos Tversky.

When you think about it, this bias, built into our brains, must have been very useful to human beings in our early days, when our survival as a species was in question. Taking chances was clearly something to be avoided, if we wanted to survive, unless the chance of failure was low or carried only a small loss. If we had been a species taking big chances, we probably wouldn’t be around today.

And our brains have not changed very much over the millennia: it’s just the situations we face today that are very different. But our brains aren’t.

I first came across loss aversion when I was studying behavioural finance, as a pension fund investment consultant many decades ago. It was totally consistent with the way in which pension fund fiduciaries behaved. Limit your losses before you go for gains. I tried to express it in a way that was succinct and easy for clients to remember: First survive, then thrive.

It’s taken for granted these days. So I was very surprised to find recently that, though the general notion of loss aversion still applies, there are circumstances in which our mental attitudes change. I’ll expand on this in a moment.

A second well-known characteristic of human beings, as we make decisions, is that we look at the near future as much more important than the long-term future. This is often called hyperbolic (that is, exaggerated) discounting: a jargon-based way of saying two things.

One is that we discount the future. In other words, the present is far more important to us than the future, and given a choice between having something soon and something in the medium to long term, we place far more value on near-term gratification.

More than that: we discount the future inconsistently. We have, for example, no problem saying that something now is worth much more to us than something in a year’s time; but we place virtually no difference between getting something in 25 years and getting that same something in 26 years. That one year of postponement makes little difference to us if it’s in the distant future, but a big difference if it’s fairly close to us.

All of that too is now accepted wisdom. And again, I was surprised to find recently that, though the general statement still applies, it’s not quite as clean as my quick description of our behaviour makes it appear.

That’s what this post is about: the fact that that accepted wisdom is more nuanced than is generally known. And it leads me to someone I’ve admired for a long time: Dr Laura Carstensen, the Fairleigh S. Dickinson Jr Professor in Public Policy and Professor of Psychology at Stanford University and founding director of the Stanford Center on Longevity.

Emotional satisfaction becomes more important when older

Laura has influenced the way I view life, following her book A Long Bright Future: happiness, health and financial security in an era of increased longevity. Essentially it says: if we knew we were going to live 100 years, would we still live our lives the same way? Go to school, work, retire, as has become customary – and then keep that retirement stretched out until 100? No, we wouldn’t, we’d pace our 100 years differently. In another blog post some time I’ll outline her ideas – but for now let’s just say that her book has changed my thoughts on life.

So, when I got a chance to chat one-on-one with Laura at a friend’s gathering recently, it was like a gift to me. I have recently been contemplating the role of chance in my life, and when I mentioned this to Laura, she promised to send me a paper by Dr Albert Bandura, the most highly cited figure in contemporary psychology, on the role of chance in life, a paper which takes my own ideas much further. But that’s incidental to this piece.

As we chatted about the choices we make, Laura mentioned two of her own papers, and sent them to me as well. And, once more, she has had a profound effect on my thinking.

One paper was on age differences in preferences.

It’s obvious that the amount of time we have left to live shrinks as we age. What isn’t obvious is that we seem implicitly to take our shrinking survival years into account when we make choices, essentially making those choices over a shrinking time horizon. We don’t just think: oh well, that’s in the future, pretty much an indefinite time away (as we do when we’re young). When we’re much older, in particular, we’re conscious of the fact that our choices will play out over a much shorter time frame. And that shrinking time horizon changes our preferences. What we value much more highly, when the future isn’t an indefinite period, is things with emotional meaning in the present. But that makes total sense, as I think about it.

More surprising is that our negativity bias (our loss aversion) in early life changes to a positivity bias in middle life and late adulthood. Not that it needs to make total sense to me, of course – it would be true regardless of my views – but the conclusions resound all the more strongly for that. And remember: these conclusions in the paper are based on rigorous experiments in which large numbers of people of different ages were given choices to make, choices that would be able to have different conclusions drawn from them, and these were the conclusions that came through.

A thought that occurs to me is that perhaps that negativity-to-positivity change as we age is one of the reasons why the U-curve of happiness by age (see Chapter 11 in my Happiness book) starts to turn up after bottoming out. I don’t know which is cause and which is effect – but the two are consistent.

We focus more on gain than loss as we age

The other paper was much more numerical, and took me longer to process. What fascinated me particularly was that it involved experiments associated with neuroimaging, that is, checking which parts of the brain are activated when choices of various kinds are considered and decisions are made. Again, the conclusion led away from conventional wisdom. It was that, as we age, we tend to consider monetary gain more importantly than monetary loss. In other words, we play down the impact of a loss, and play up the impact of a gain. This seems directly opposite to the loss aversion that we’ve known as a human characteristic. Apparently, though, it’s more a characteristic of younger humans, and not so much with older ones. When we have less time ahead of us, we’re thinking of thriving more than of surviving. That makes sense to me: at this age most of my surviving is behind me, and I look forward much more to thriving in the time I have left.

Anyway, put these two of Laura’s papers together, and they change what I have learned about human choices. Not only that: they have put me more at ease with myself, as I think about achieving positive outcomes rather than avoiding negative outcomes, and I think about emotional rather than material satisfaction. I feel somehow freer – and I hope this makes you feel that way too.

 

Don Ezra, now retired, is the former Co-Chairman of global consulting for Russell Investments worldwide, and the author of “Life Two: how to get to and enjoy what used to be called retirement”. This article is general information and does not consider the circumstances of any investor.

 

10 Comments
Di
August 01, 2023

First time I've seen some of my own thoughts put forth so well.

James
July 30, 2023

I love this article - I run my own SMSF and have surprised myself reducing exposure to risk averse shares and going for more alpha. Thanks

Jay
July 29, 2023

I don't quite understand this article, seems vague. It seems to me that many the current old generation are ridiculously risk averse. Or more specifically averse to spendig down their principle. One couple I know are in their 80s, worth at least 10 million in property, cash and shares with significant income streams. And yet they can seem reluctant to go on what might be their last holiday due to the cost and are upset that they aren't entitled to the pension. It may be more of a case of maths aversion. And yet they were savvy enough to build all that up..It is a common story. Perhaps maths aversion results in some people doing well as they are ignorant of their investment risk.

Lyn
August 01, 2023

There is recogniton of maths aversion -- dyscalculia, never knew so not being cocky, looked up few days ago to see if recognised, relative fazes & glazes re figures but not daft as doctor and quotes from memory reams of research own subject, wish I'd looked up before as would have been more patient.

Allan
July 28, 2023

"[...] ... ; or, if the odds stay at 50/50, then a win is worth $700 versus a loss costing us only $300. [...]"

'Non sequitur' has it that this flimsy finale in Don's 2nd paragraph is away with the financing fairies.

Dudley
July 28, 2023

As (1 - Age_Currently / Expected_Age_at_Death) decreases,

return on capital:
= PMT(5%, (97-77), -1, 1)
= 5% / y

becomes less significant than

return of capital:
= PMT(5%, (97-77), -1, 0)
= 8% / y

For same investment risk can spend more on thriving by spending capital that was previously used as survival insurance.

Inverse of smaller Age_Currently / Expected_Age_at_Death ratio where amount saved is more significant than return on capital saved.

David Toohey
September 01, 2023

I don't follow your return on capital formula, nothing like anything I've seen before - sorry - but I like your summary: "For same investment risk can spend more on thriving by spending capital that was previously used as survival insurance."

I found the same thing when I modeled the MyTelos lifetime investing app (now discontinued). The idea was to create a lifepath at all ages of the portfolio volatility so that the volatility of the 1 year lookahead annuity value was equal at all ages. Obviously, the portfolio volatility gradually decreased as the age approached the retirement age, but then it increased slightly again past retirement age, and started to really kick up past age 95.

For example, as you approach age 100 you have an 80% chance of needing your money beyond age 101, whereas when you're 65 it's more 98% chance of needing your money at age 66. So you see, the 100yo can gamble a little bit more given the much-reduced life expectancy.

Michael2
July 28, 2023

Great article, very thoughtful as were the other articles by Don, which I have saved and used as a review to my investments

Marjorie
July 27, 2023

Fantastic insight - easy to understand. It’s an emotional shock to realise we don’t live forever. I’m pretending we do and building assets for a prosperous future - but also enjoying the day to day and activities such as reading ‘wisdom’ such as your own and Dr Laura’s. Many thanks Marjorie J

Allan
July 29, 2023

"[...] It's an *emotional shock* to realise we don't live forever. I'm pretending we do and building assets for a prosperous future - [...]" Well said, Marjorie. I'm flatly refusing to get any older from here-on-in(vesting), and should have *started* much earlier. If I have no option but to age then it's only gonna be in time to come...and then some. "The temporal has no close".

 

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