The Flaw of Averages

People misunderstand what average means in all walks of their lives, not only in their financial matters. There are a few books out that explain this misunderstanding, most of them business books because managers can rarely afford making these kind of mental errors.

Here’s a website by Stanford professor Sam Savage that touches briefly on how thinking about averages can get you into trouble in many areas of life and work.

The below short article by Sheldon McFarland explains how these flaws work in your personal finances.

 

The Law of Averages comes from a mistaken belief that events will even out in a short period of time. What is often misunderstood is that a larger sample (longer time period) may have “return to the average,” this is not to say that it will in your remaining lifetime! Another area this misconception occurs is when people think “it has to happen this time,” and then are surprised that it didn’t.

Finally, this disclaimer … “Past performance is not indicative of future results” … is a disclaimer you will see on all marketing and advertising in the financial industry. It means the traveler’s past experience was shallow water until he steps into deeper water. If he survives the deeper water, he may arrive at shallower water again – but he is unaware of it until he gets to shallower water again; just as he was unaware of the deeper water until he got there. The unknown in this example is the question – How strong is the current? Shallow water may be walkable … but deeper water?

This is not to say woes me and throw your hands up. I simply say that going through life with thoughts of never having to make adjustments is unrealistic. When deep water economies and markets arrive, adjustments need to be made. Planning ahead to take life preservers and paddles along improves the odds of a successful crossing.

In retirement planning, there are dynamic tools that signal when and what kind of retirement spending adjustments to make (research has shown allocation changes are not effective).

For those reader’s who like math … see Jensen’s inequality and Karamata’s inequality.

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