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:

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.
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