The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty

CHAPTER 21

Your Retirement Portfolio

Nearly all of us share a problem that lies deep in Flaw of Averages territory: investing for retirement.

In Die Broke, Stephen Pollan and Mark Levine argue that wealth is of no value once you’re dead, so make sure your family is taken care of while you are still alive and aim to die with nothing beyond your personal possessions.¹ This sounds about right to me, but whether or not you agree with this philosophy, it is a useful starting point for retirement planning. If, instead, you want to die with a specific sum in the bank, the following discussion requires only slight modification.

So suppose your retirement fund has $200,000 and you expect to live another 20 years. In fact, to simplify the analysis, let’s assume that through some arrangement with the devil you know that you will die in exactly 20 years. How much money can you withdraw per year to achieve that perfect penniless state upon your demise? We will assume the money is invested in a mutual fund that has decades of history and that is expected to behave in the future much as it has in the past. Recent events have shown what a bad assumption this can be, but it is still much better than using averages alone and will be useful here for exposition. The annual return has fluctuated, year by year, with an average year returning 8 percent. Traditionally, financial planners have put this sort of information into a retirement calculator that starts with your $200,000, and then subtracts ...