Sam L. Savage, a consulting professor at Stanford University, coined a phrase which—if you were hitherto unfamiliar with—ought to completely change the way you plan for retirement. This phrase, “the flaw of averages,” comes from his book The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty. In this book, he explains why financial planning that requires guesswork shouldn't be done on the basis of averages. One way he gets the point across is to use the following analogy:
Consider the case of the statistician who drowns while fording a river that he calculates is, on average, three feet deep. If he were alive to tell the tale, he would expound on the “flaw of averages,” which states, simply, that plans based on assumptions about average conditions usually go wrong. This basic but almost always unseen flaw shows up everywhere in business, distorting accounts, undermining forecasts, and dooming apparently well-considered projects to disappointing results.1
What does this mean for retirement planning? Well, consider the way in which most of us go about planning for our old age: we find out what the average lifespan for our demographic is, then determine our average yearly spendings, and perform simple multiplication to figure out how much we should be setting aside. The trouble with this model is that,
A) Many people live well past the average life expectancy
B) There will be years when, owing to circumstances beyond your control, your spending will be considerably higher than your “average.”
Following Savage's reasoning, then, the best way you can safeguard against this is to overestimate. You may not live to be a century, but you should plan as though you will. You may not spend more than your present-day average spendings, but again, you should plan as though you will. A significant portion of our elderly population find themselves running out of money by the time they hit their late eighties/nineties largely in part because they have planned their futures based on the averages.
The lesson to be learned here is that if you are going to use averages as any sort of benchmark, treat them as an absolute minimum which must be added to...because as Savage concludes, “decisions based on average numbers are wrong on average.”
1. Savage, Sam. The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty. Hoboken, New Jersey: John Wiley & Sons Inc, 2009. Print.