Cognitive Abilities and Financial Decisions

This chapter demonstrates that a person’s level of cognitive abilities is a key determinant of financial decisions. Households with high cognitive abilities tend to participate more in the stock market and accumulate more financial wealth than households with low cognitive abilities. Upon participation, portfolio performance improves with experience but it is negatively correlated with age due to the adverse effects of cognitive aging. A portfolio choice model that accounts for cognitive abilities can also provide a parsimonious explanation to why retail investors hold underdiversified portfolios, engage in active trading, and overweight local stocks. Specifically, portfolio distortions by smart investors reflect an informational advantage and generate higher risk-adjusted returns. In contrast, the distortions by investors with lower abilities arise from psychological biases and result in low risk-adjusted performance. INTRODUCTION This chapter focuses on an important, but previously unexplored, determinant of stock investment decisions, namely, cognitive abilities. At first glance, intelligence should be correlated with success in financial decisions. However, directly establishing this link is difficult because data sets that contain both measures of cognitive abilities and financial performance are hard to obtain. Even with rich data sets, the impact of cognitive abilities on financial decisions may be difficult to quantify because this relation is likely to be complex and multifaceted. For example, predicting whether the quality of investment decisions would improve or deteriorate with age poses numerous problems. Although older investors would accumulate