A column by Gail MarksJarvis in the Chicago Tribune over the weekend talked about the danger of planning your retirement with average returns. It’s a simplified story quoting “experts” rather than explaining the math. Pages 153-156 of Basic Personal Finance illustrate this exact topic with a concrete example. It’s based on The Flaw of Averages, a book by former professor, Sam Savage.
Basic Personal Finance uses a scenario developed in the math appendix: a 35-year plan to live off $80,000 per year from a portfolio of $1.5M that continues to grow at 4%. Using average returns, the portfolio lasts exactly 35 years. Simulating returns with a normal distribution with 4% average and 3% standard deviation, the portfolio runs out of money before year 35 over half the time (53%). As Sam Savage said, “answers from average data are wrong on average.” Here’s the graph from the book that shows 5 random trials along with the certain return plot.
Lesson: either add some stochastic element to your retirement planning or add a good cushion to make sure you can weather the years with returns below the average you plan to earn.