Breaking the Law ... of averages

Let me ask you a question. If you put your left foot in a bucket filled with ice cold water and your right foot in a bucket of boiling hot water would you, on the average, be comfortable? Of course not! Yet these types of assumptions are the foundation of financial planning.

In every financial plan we make assumptions about inflation, returns on investments, income, and life expectancy - and we know our plan is in error. That is okay as long as you consider two issues:

• Your plan is a roadmap. It is vital that you regularly (annually) make adjustments to keep on the proper course.
• Don't take the plan results literally. A result of $487,823.69 should be interpreted as $500,000.

The average life expectancy for a 65 year old in 2004 was 18.7 years. That means that half the people will die sooner, but half will live longer. If your financial plan provides enough income for the average life expectancy, there is a 50/50 chance you will run out of money before you die!

The moral is you have to keep the proper perspective when dealing with averages, especially when it comes to investments. We will examine that aspect of averages in our next Moment on Money.

Photo on Flickr by Tony_ia

Comments

[Mark Cahill]

Great post! I never really thought about the problem with planning for "averages" before.

My mother was negotiating the sale of a business, and they buyer was offering yearly payments for life. She hedged for a while, then accepted, and they signed the deal. As they were wrapping up, in her office, the attorney for the buyer started to ask about the pictures of all the old folks on the wall. "Who's that?" He'd ask and my mother would answer (insert the relative, mom, Uncle Buzz, etc.) then (politely) he asked if he/she was still alive. The answer was generally yes, and that person was generally on the far side of 95 years old.

At the realization, his face blanched white...he realized his actuarial tables had most probably let him down.