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

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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 Savage-known 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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Product details

  • Hardback | 416 pages
  • 157.48 x 228.6 x 35.56mm | 635.03g
  • New York, United States
  • English
  • 1. Auflage
  • 0471381977
  • 9780471381976
  • 323,150

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Despite all its promise, the Information Age is also laden with a dizzying array of technological, economic, and political uncertainties. While the electronic spreadsheet brought the power of business modeling to tens of millions, in so doing, it also paved the way for an epidemic of what Sam Savage calls the Flaw of Averages. This set of systematic errors occurs in all types of business and scientific endeavors when smart people focus on single average values in the face of uncertainty and risk, and it is an accessory to the economic catastrophe that culminated in 2008. The Flaw of Averages also ensures that plans based on averages of such uncertainties as customer demand, completion time, and interest rate are below projection, behind schedule, and beyond budget. In his book, Savage draws on recent breakthroughs in technology, along with new data structures and management protocols, to offer an approach to curing the Flaw of Averages.

Savage begins by providing a basis for intuitively grasping and visualizing risk and uncertainty, using simple everyday props such as game-board spinners and dice. He refers to such statistical jargon as standard deviation and covariance as Red Words, and instead uses straightforward, everyday language throughout the book. He does not assume any statistical background on the part of the reader, but claims that for those with extensive training in the field, the first section of the book will repair the damage. He then describes how risk and uncertainty are handled in the field of finance, where the Flaw of Averages was first systematically conquered by Modern Portfolio Theory. Savage describes how the recenteconomic turmoil was caused in part by clinging blindly to this early work while not adhering to its fundamental principles. He then shows how these principles still form an excellent foundation for managing uncertainty and risk in other areas of industry and government, and provides examples in supply chain management, project portfolios, national defense, healthcare, climate change, and even sex.



In the book's final section, Savage reveals current developments in the emerging field of Probability Management--a path towards increased transparency and a potential cure for the Flaw of Averages. Finally, the book includes a Red Word Glossary that defines statistical terms in plain English to assist readers in defending themselves against those wielding technical mumbo jumbo.



The goal of The Flaw of Averages is to help you make better judgments involving uncertainty and risk, both when you have the leisure to deliberate, and, more importantly, when you don't. Its approach of a more transparent representation of uncertainty is helping people and some big companies to make better decisions today.
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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 Economics



A Groundbreaking must-read for anyone who makes business decisions in the face of uncertainty



As 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.
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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
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About Sam L. Savage

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.
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Rating details

324 ratings
3.84 out of 5 stars
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4 35% (114)
3 23% (76)
2 10% (31)
1 1% (4)
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