Finance and the Flaw of Averages
From the new book The Flaw of Averages, an explanation of why modern finance means that 50% of people who invest intelligently will run out of money before they die.
Assume that our retirement fund is $200,000 dollars and our life expectancy is 20 years. Assume that we invest our money in a mutual fund with a good record. Their annual return has fluctuated from year to year with an average year return of 8%. Our adviser calculates that we can withdraw $21,000 a year and this will exhaust our funds in exactly 20 years. This is illustrated below by the first figure.
However, of course there is no reason to believe that our year return will be exactly 8%. So we look at what our resources will be with some random variations in the return.
The lower figure shows a dozen potential wealth paths simulated at random by a computer. Here we see that about 50 percent of these (those with dark lines) leave us without any money before you die!
[via Chance]