Image by Kevin Dooley

Advice is what we ask for when we already know the answer but wish we didn’t.
—Erica Jong

Let’s say you’re just starting your adult life, and want to plan out your finances. First off, you are to be congratulated. Most people don’t put much thought into the subject until later in life, and in so doing, make things considerably harder on themselves. You plainly are much more clever than they are.

Let’s put together a plan based on the sort of generic, conventional wisdom you’ll find in endless personal finance books, Web sites, radio programs, and seminars. Let’s say you start your career at age 22, and want to retire at age 65. You’d like to earn $40,000 per year from your portfolio after you retire. Using the traditional 4% rule, that means you’ll need a nice, even $1 million to retire. How much should you save for retirement each year?

Well let’s head over to one of the many retirement calculators out there on the Web and find out. From 1900 to 2011, the average return of the stock market has been 11.37%. You can easily earn the average stock market return by buying an index fund, so let’s plug that into the calculator as your return, with $1,000,000 as your goal, and starting and ending ages of 22 and 65.

The result: you need to save less than $1200 per year! That’s the extraordinary power of compounding. Because you so wisely started out so young, time is on your side. So just start socking away $100 per month, stick it all in an index fund, and when you retire in 43 years, you’ll be all set.

That wasn’t so hard, right? There’s only one problem. It’s all bullshit.

The Devil is in the Details

Ok, so it isn’t quite all bullshit. After all, the most effective lies contain kernels of truth. The part about the power of starting young, for example, is absolutely true. Unfortunately, though, the very power it lends to your ability to grow your wealth also hugely magnifies the effect of all the other distortions, invalid assumptions, and fallacies of our little “plan” — and there are many. Layers upon layers of them. So many, in fact, that it would be almost impossible to cover them all thoroughly in a good-sized book, never mind one post.

Every one of these pitfalls is distressingly commonplace. While it’s true that few sources of retirement advice make all of the mistakes in the above analysis, almost all of them make some. Over the next few days, we’ll take a tour through some of the more egregious ones, and see what the results are more likely to look like in the real world for a hypothetical youngster who chooses to follow this plan.

Take a moment to reread the plan before continuing, and see how many problems you can spot.

Fallacy #1 — “Average” Return

This first fallacy is one of the worst. It’s also one of the most common. While it has long been a favorite tool of shysters and crooks, it also crops up routinely among many of the most respected sources of financial analysis available. Even the most knowledgeable and scrupulous commentators — people who really ought to know better, and are genuinely honest — frequently run afoul of it. Why? Because it’s so easy to overlook. This is especially troubling, since it can lead to some truly spectacular distortions. So what is it, precisely?

Let’s say you invest $100 for 5 years. You’re an awesome investor, so you earn an average return of 50%. How much money would you have at the end? A quick calculation says you should end up with $759. Nice work!

Expectation vs. Reality

But wait, your account only has $10 in it! How can that possibly be? You must have been defrauded. Time to call the SEC, right?

Well, not so fast. Let’s say you had a rough first year and lost 99% of your money. Your skills greatly improved in the other 4 years, though. You earned a whopping 199% in year 2, and 50% in years 3, 4, and 5. Your “average” return, then, is:

(-99% + 199% + 50% + 50% + 50%) / 5 = 50%

Run your $100 through those results though, and you will see that you in fact wind up with just $10. So you can see, your average return really was 50%, and you were not defrauded. Yet rather than greatly compounding your wealth, you lost 90% of your money.

Never Use Average Return

Let me be blunt. The entire concept of “average return” for an investment technique, index, or mutual fund is utterly useless. Worse than useless, in fact, because it is so easily misunderstood.

The figure you actually want to use is something called the Compound Average Growth Rate, or CAGR. This figure gives an accurate accounting of what would really happen if you invested a sum of money over time.

Taking another look at our above example, while the average return is 50%, the CAGR is approximately -37%. Plug that number in for 5 years, and you’ll see that it accurately predicts your $10 final balance. Quite a difference, eh?

Unfortunately, many people’s eyes glaze over when they see acronyms like CAGR scattered among lots of financial gobbledygook. It’s also much harder to compute than a simple average. The uninformed will often latch onto a simpler term like “average return,” since it is much easier to understand. Or so they think.

You know better, now, though. Next time you see the term “average return” or anything similar thrown around, your Spidey sense should go off immediately. Chances are extremely high that whoever is using it is either misinformed, misleading you, or misusing the term. You had best find out which.

The Fallacy in Action

Let’s see how this fallacy plays out for our hypothetical retirement plan. As it turns out, while the average stock market return from 1900 to 2011 was indeed 11.37%, the CAGR was only 9.49%. That’s still pretty good, though, right? Let’s plug that into our retirement calculator along with our $1200 in annual savings and see how we did.

Uh oh. Instead of $1 million, our hypothetical youngster has ended up with only $611,000. That’s right, this one mistake cost him nearly $400,000. Assuming this was his only mistake, if he follows the 4% rule, he’ll have to settle for living on less than $25,000, rather than the $40,000 he had hoped for.

Sadly, though, our poor youngster has run afoul of many more pitfalls. Stay tuned.