The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty

The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty

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By (author) Sam L. Savage, Illustrated by Jeff Danziger, Foreword by Harry M. Markowitz

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  • Publisher: John Wiley & Sons Inc
  • Format: Hardback | 416 pages
  • Dimensions: 157mm x 229mm x 36mm | 635g
  • Publication date: 10 July 2009
  • Publication City/Country: New York
  • ISBN 10: 0471381977
  • ISBN 13: 9780471381976
  • Sales rank: 183,503

Product description

A must-read for anyone who makes business decisions that have a major financial impact. As the recent collapse on Wall Street shows, we are often ill-equipped to deal with uncertainty and risk. Yet every day we base our personal and business plans on uncertainties, whether they be next month's sales, next year's costs, or tomorrow's stock price. In The Flaw of Averages , Sam Savageknown for his creative exposition of difficult subjects describes common avoidable mistakes in assessing risk in the face of uncertainty. Along the way, he shows why plans based on average assumptions are wrong, on average, in areas as diverse as healthcare, accounting, the War on Terror, and climate change. In his chapter on Sex and the Central Limit Theorem, he bravely grasps the literary third rail of gender differences. Instead of statistical jargon, Savage presents complex concepts in plain English. In addition, a tightly integrated web site contains numerous animations and simulations to further connect the seat of the reader's intellect to the seat of their pants. The Flaw of Averages typically results when someone plugs a single number into a spreadsheet to represent an uncertain future quantity. Savage finishes the book with a discussion of the emerging field of Probability Management, which cures this problem though a new technology that can pack thousands of numbers into a single spreadsheet cell. Praise for The Flaw of Averages "Statistical uncertainties are pervasive in decisions we make every day in business, government, and our personal lives. Sam Savage's lively and engaging book gives any interested reader the insight and the tools to deal effectively with those uncertainties. I highly recommend The Flaw of Averages ." - William J. Perry , Former U.S. Secretary of Defense "Enterprise analysis under uncertainty has long been an academic ideal...In this profound and entertaining book, Professor Savage shows how to make all this practical, practicable, and comprehensible." - Harry Markowitz , Nobel Laureate in Economics

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Author information

Sam L. Savage is a Consulting Professor of Management Science and Engineering at Stanford University, and a Fellow of the Judge Business School at the University of Cambridge.

Back cover copy

PRAISE FOR "THE FLAW OF AVERAGES""Statistical uncertainties are pervasive in decisions we make every day in business, government, and our personal lives. Sam Savage's lively and engaging book gives any interested reader the insight and the tools to deal effectively with those uncertainties. I highly recommend "The Flaw of Averages."" --William J.Perry, Former U.S. Secretary of Defense"Enterprise analysis under uncertainty has long been an academic ideal. . . . In this profound and entertaining book, Professor Savage shows how to make all this practical, practicable, and comprehensible." --Harry Markowitz, Nobel Laureate in EconomicsA Groundbreaking must-read for anyone who makes business decisions in the face of uncertaintyAs the recent collapse on Wall Street shows, we are often ill-equipped to deal effectively with uncertainty and risk. Yet every day we base our personal and business plans on these kinds of uncertainties, whether they be next month's sales, next year's costs, or tomorrow's stock price.In "The Flaw of Averages," Sam Savage--known for his creative exposition of difficult subjects--describes common avoidable mistakes in assessing risk in the face of uncertainty. He explains why plans based on average assumptions are wrong, on average, in areas as diverse as finance, healthcare, accounting, the war on terror, and climate change. Instead of the usual anachronistic statistical jargon, Savage presents complex concepts in plain English, connecting the seat of the reader's intellect to the seat of their pants.Savage also presents the emerging field of Probability Management aimed at curing the Flaw of Averages through more transparent communication of uncertainty and risk. Savage argues that this is a problem that must be solved if we are to improve the stability of our economy, and that we cannot repeat the recent mistakes of applying "steam era" statistics to "information age" risks.

Flap copy

Despite all its promise, the Information Age is also laden with adizzying array of technological, economic, and politicaluncertainties. While the electronic spreadsheet brought the powerof business modeling to tens of millions, in so doing, it alsopaved the way for an epidemic of what Sam Savage calls the Flaw ofAverages. This set of systematic errors occurs in all types ofbusiness and scientific endeavors when smart people focus on singleaverage values in the face of uncertainty and risk, and it is anaccessory to the economic catastrophe that culminated in 2008. TheFlaw of Averages also ensures that plans based on "averages"of such uncertainties as customer demand, completion time, andinterest rate are below projection, behind schedule, and beyondbudget. In his book, Savage draws on recent breakthroughs intechnology, along with new data structures and managementprotocols, to offer an approach to curing the Flaw of Averages. Savage begins by providing a basis for intuitively grasping andvisualizing risk and uncertainty, using simple everyday props suchas game-board spinners and dice. He refers to such statisticaljargon as "standard deviation" and "covariance" as RedWords, and instead uses straightforward, everyday languagethroughout the book. He does not assume any statistical backgroundon the part of the reader, but claims that for those with extensivetraining in the field, the first section of the book will repairthe damage. He then describes how risk and uncertainty are handledin the field of finance, where the Flaw of Averages was firstsystematically conquered by Modern Portfolio Theory. Savagedescribes how the recenteconomic turmoil was caused in part byclinging blindly to this early work while not adhering to itsfundamental principles. He then shows how these principles stillform an excellent foundation for managing uncertainty and risk inother areas of industry and government, and provides examples insupply chain management, project portfolios, national defense, healthcare, climate change, and even sex.In the book's final section, Savage reveals currentdevelopments in the emerging field of ProbabilityManagement--a path towards increased transparency and apotential cure for the Flaw of Averages. Finally, the book includesa Red Word Glossary that defines statistical terms in plain Englishto assist readers in defending themselves against those wieldingtechnical mumbo jumbo.The goal of "The Flaw of Averages" is to help you makebetter judgments involving uncertainty and risk, both when you havethe leisure to deliberate, and, more importantly, when youdon't. Its approach of a more transparent representation ofuncertainty is helping people and some big companies to make betterdecisions today.

Table of contents

Preface xv Acknowledgments xix Introduction Connecting the Seat of the Intellect to the Seat of the Pants 1 FOUNDATIONS Part 1 The Big Picture 9 Chapter 1 The Flaw of Averages 11 Chapter 2 The Fall of the Algebraic Curtain and Rise of the Flaw of Averages 22 Chapter 3 Mitigating the Flaw of Averages 26 Chapter 4 The Wright Brothers Versus the Wrong Brothers 34 Chapter 5 The Most Important Instrument in the Cockpit 40 Part 2 Five Basic MINDles for Uncertainty 45 Chapter 6 MINDles Are to MINDs What HANDles Are to HANDs 49 Chapter 7 Mindle 1: Uncertainty Versus Risk 52 Chapter 8 Mindle 2: An Uncertain Number Is a Shape 55 Chapter 9 Mindle 3: Combinations of Uncertain Numbers 67 Chapter 10 I Come to Bury SIGMA, Not to Praise it 78 Chapter 11 Mindle 4: Terri Dial and the Drunk in the Road 83 Chapter 12 Who Was Jensen and Why Wasn't He Equal? 91 Chapter 13 Mindle 5: Interrelated Uncertainties 98 Part 3 Decisions and Information 109 Chapter 14 Decision Trees 111 Chapter 15 The Value of Information 118 Part 4 The Seven Deadly Sins of Averaging 127 Chapter 16 The Seven Deadly Sins of Averaging 129 Chapter 17 The Flaw of Extremes 133 Chapter 18 Simpson's Paradox 139 Chapter 19 The Scholtes Revenue Fallacy 142 Chapter 20 Taking Credit for Chance Occurrences 147 APPLICATIONS Part 5 The Flaw of Averages in Finance 155 Chapter 21 Your Retirement Portfolio 157 Chapter 22 The Birth of Portfolio Theory: The Age of Covariance 163 Chapter 23 When Harry Met Bill(y) 169 Chapter 24 Mindles for the Financial Planning Client 175 Chapter 25 Options: Profiting from Uncertainty 181 Chapter 26 When Fischer and Myron Met Bob: Option Theory 192 Chapter 27 Prices, Probabilities, and Predictions 200 Part 6 Real Finance 213 Chapter 28 Holistic Versus Hole-istic 215 Chapter 29 Real Portfolios at Shell 222 Chapter 30 Real Options 228 Chapter 31 Some Gratuitous Inflammatory Remarks on the Accounting Industry 236 Part 7 The Flaw of Averages in Supply Chains 245 Chapter 32 The DNA of Supply Chains 247 Chapter 33 A Supply Chain of DNA 254 Chapter 34 Cawlfield's Principle 257 Part 8 The Flaw of Averages and Some Hot Button Issues 263 Chapter 35 The Statistical Research Group of World War II 265 Chapter 36 Probability and the War on Terror 272 Chapter 37 The Flaw of Averages and Climate Change 289 Chapter 38 The Flaw of Averages in Health Care 299 Chapter 39 Sex and the Central Limit Theorem 307 PROBABILITY MANAGEMENT Part 9 Toward a Cure for the Flaw of Averages 317 Chapter 40 The End of Statistics as You Were Taught It 319 Chapter 41 Visualization 324 Chapter 42 Interactive Simulation: A New Lightbulb 328 Chapter 43 Scenario Libraries: The Power Grid 332 Chapter 44 The Fundamental Identity of SLURP Algebra 341 Chapter 45 Putting It into Practice 343 Chapter 46 The CPO: Managing Probability Management 354 Chapter 47 A Posthumous Visit by My Father 364 Red Word Glossary 367 Notes 371 About the Author 382 Index 383