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The impact of aging on your financial decision making

Closing out last week's Morningstar investment conference was Harvard's Robert I. Goldman Professor of Economics David Laibson. He tackled the unpleasant but important topic of cognitive decline among the elderly and the impact it has on their financial and investing decisions.

Combining information from this summary of Laibson's address as well as this follow-up interview following the address, here are some of the highlights that stood out:

Laibson highlighted two kinds of intelligence. Crystallized intelligence is the ability to accumulate wisdom, experiences, skills, and knowledge. This type of intelligence rises until age 60 when dementia is more likely to set in. Fluid intelligence is the ability to solve new problems. This type of on-the-fly intelligence peaks at 20 and then declines rapidly.

According to memory and analytics tasks performed by all age groups, 80-year-olds perform at the bottom 16th percentile. Moreover, age is a greater hindrance to economic rationality than is being low-income or of low-education. As a result, the retired are among the most impaired in terms of economic reasoning. The prevalence of dementia (or cognitive impairment) plays a huge role. Laibson noted a startling but compelling statistic — the likelihood of developing dementia doubles with every five years of age after age 60.

Unfortunately, in the 80s, about half the U.S. population either has full blown dementia or cognitive impairment, which is short of dementia, but still a clinical diagnosis — half the population. So, every investor in their 60s should be preparing for the possibility, an enormous possibility, that things are going to go badly in the 80s.

Laibson says that risk-adjusted returns for investors in their 80s run about 3% below "baseline" (which I don't see precisely defined, but from context seems to indicate what other investors of other ages get when investing with a comparable set of goals). This also helps explain why 20% of American seniors report being taken advantage of financially.

Laibson's primary point is that investors need to plan ahead for the potential that cognitively they just may not be as sharp in their 80s as they were in their 60s. Naturally, people aren't always aware of the decline as it happens, which makes planning ahead for it crucial.

In terms of investing, Laibson's opinion appears to be that all "complicated" aspects of your investment strategy ought to be wound down (or on a very specific, written plan made out years in advance) before an investor reaches these ages.

There are other applications as well. One important one is in the area of estate planning and making sure the four primary estate documents are in order while you're still relatively young.

What are those documents? You should have a durable power of attorney or a springing power of attorney. You should have a living revocable trust that protects your assets. You should then have two health-care documents. A health-care proxy, that basically assigns someone to help you make health-care choices if you are no longer mentally competent, and you should have a living will, which is providing instructions to that person about what kind of care you'd like. How extensive intervention do you want if you are, say, on life-support.

While this isn't a pleasant topic, it's an important one. Reading one or both of the links above is probably time well spent. Beyond that, putting in the effort to simplify your investing/financial decision-making as you get older is smart. Think of it as doing a favor for your older, potentially less-capable self. If none of this decline happens to you, you still haven't lost anything, as your financial plan will be that much more organized and well thought out.

That's a benefit worth working for at any age.

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