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

by Sam L. Savage; Illustrator: Jeff Danziger

ISBN13: 9780470488119

ISBN10: 0470488115

Format: eBook

Pub. Date: 2009-05-01

Publisher(s): Wiley

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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.

Preface
Acknowledgments
Introduction: Connecting the Seat of the Intellect to the Seat of the Pants.
You cannot learn to ride a bicycle from a book, and I claim the same is true for coping with uncertainty. Paradoxically, this book attempts to do what it claims is impossible.
Foundations.
The Big Picture.
The Flaw of Averages.
In planning for the future, uncertain outcomes are often replaced with single "average" numbers. This leads to a class of systematic errors which I call the Flaw of Averages, which explains among other things why forecasts are always wrong.
The Fall of the Algebraic Curtain and Rise of the Flaw of Averages.
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 the Flaw of Averages.
Mitigating the Flaw of Averages.
New technologies are illuminating uncertainty much as the light bulb illuminates darkness. Probability Management is a scientific approach to harnessing these developments to cure the Flaw of Averages.
The Wright Brothers Vs. the Wrong Brothers.
The success of the Wright Brothers airplane was the result of carefully constructed models that they tested in their wind tunnel. Similar models can help us manage uncertainty and risk.
The Most Important Instrument in the Cockpit.
The proper use of models, like the instruments in a plane, are not obvious.
Five Basic Mindles for Uncertainty.
Mindles are to Minds what Handles are to Hands.
Just as industrial designers develop handles to help us grasp the power of physics with our hands, informational designers develop Mindles (first syllable rhymes with mind) to help us grasp power of information with our minds. Section 2 will povide some important Mindles for grasping uncertainty.
Mindle 1: Uncertainty vs. Risk.
These two concepts are often used interchangeably but they shouldn't be. Uncertainty is an objective feature of the universe, while risk is in the eye of the beholder.
Mindle 2: An Uncertain Number is a Shape.
Even graduates of statistics courses have a hard time visualizing uncertainty. A shape, a simple bar graph called the histogram, does the trick. Try running a simulation in your head or better yet, on your web browser at lawOfAverages.com.
Mindle 3: Combinations of Uncertain Numbers.
When uncertain numbers are added or averaged, the chance of extreme events goes down. I cover a case study in the film industry.
I Come to Bury Sigma Not to Praise it.
Just as the height and weight of a criminal suspect has been superseded by surveillance videos and DNA samples, Sigma is pushing obsolescence.
Mindle 4: Terri Dial and the Drunk in the Road.
A banking executive discovers the Strong Form of the Flaw of Averages: average inputs don't always result in average outputs. Designing an incentive plan around your average employee is systematically erroneous.
Who Was Jensen and Why Wasn't he Equal?
The Nuts and Bolts of the Strong Form of the Flaw of Averages.
This chapter shows how to identify the Flaw of Averages before it occurs by understanding your options and restrictions.
Mindle 5: Interrelated Uncertainties.
Interrelated uncertainties are at the heart of modern portfolio theory. They are best understood in terms of scatter plots.
Decisions and Information.
Decision Trees.
Decision Trees are a powerful Mindle for thinking through decisions in the face of uncertainty.
The Value of Information. Because There Isn't Anything Else.
The Flip Side of Decision Trees. Information is the compliment of uncertainty. What is it worth to find things out?
The Seven Deadly Sins of Averaging.
The Seven Deadly Sins of Averaging.
So here they are the Seven Deadly Sins, all eleven of them. And the 12th deadly sin is believing there won't be even more tomorrow.
The Flaw of Extremes. Viewing uncertainties solely in terms of non-average outcomes also leads to devastatingly wrong answers and policy decisions.
Simpson's Paradox.
Imagine a weight loss treatment that makes people lose weight on average, unless they are either male or female, in which case it makes them gain weight on average.
The Scholtes Revenue Fallacy.
Suppose you have various product lines with different unit sales. The average unit sales times the average profit per unit might be positive while your average profit might be negative.
Taking Credit for Chance Occurrences.
If your retirement fund will last you 20 years given average returns, then you are just as likely as not to suffer financial ruin before you get there.
Applications.
The Flaw of Averages in Finance.
Your Retirement Portfolio.
If your retirement fund will last you 20 years given average returns, then you are just as likely as not to suffer financial ruin before you get there.
The Birth of Portfolio Theory: The Age of Covariance.
Harry Markowitz started a revolution in Finance in the early 1950s by explicitly recognizing risk return tradeoffs.
When Harry Met Bill(y)
Bill Sharpe extended the work of Markowitz, and brought it into widespread practice.
Mindles for the Financial Planning Client.
How the pros explain this stuff to their clients.
Options: Profiting from Uncertainty.
The idea behind options is to exploit uncertainty through an understanding of the Strong Form of the Flaw of Averages.
When Fischer and Myron met Bob: Option Theory.
The theory of three economists led to the Trillion Dollar Derivatives industry.
Prices, Probabilities and Predictions
The new phenomenon of Prediction Markets is changing the way we perceive and report uncertain events such as political races.
Real Finance.
Holistic vs. Hole-istic.
When people invest in portfolios of oil exploration sites, they often use the hole-istic approach. That is, they rank the places to drill hole by hole, then start at the top and go down the list until they run out of money. This ignores the holisitc effects of portfolios.
Real Portfolios at Shell.
For several years, Shell has been using Probability Management to manage its portfolios of petroleum exploration sites in a more holistic manner.
Real Options.
An example of a Real Option is the gas well in which you have the choice of whether or not to pump depending on the price of gas.
Some Gratuitous Inflammatory Remarks on the Accounting Industry.
You can't rely on accountants to detect risks because Generally Accepted Accounting Principles are built on the Flaw of Averages
The Flaw of Averages in Supply Chains.
The DNA of Supply Chains.
The inventory problem introduced in Chapter 1 is at the heart of all supply chains.
A Supply Chain of DNA.
When stocking out is not an option.
Cawlfield's Principle.
A manager at Olin creates a simulation to get two divisions of his organization to work as a team and discovers a general principle in the process.
The Flaw of Averages and Some Hot Button Issues.
The Statistical Research Group of WWII.
In which I describe the exciting environment in which my father became a statistician.
Probability and the War on Terror.
Two inescapable statistical trademarks of the war on terror are the problem of false positives and implications of Markov Chains.
The Flaw of Averages and Climate Change.
The earth's average temperature may actually be going down, not up, but you won't be happy when you find out why. The Flaw of Averages permeates this issue.
b>Chapter 38: The Flaw of Averages in Healthcare
Treating the average patient is not healthy.
Sex and the Central Limit Theorem.
Women have a diversified portfolio of two X chromosomes while men have only one. Apparently it makes a difference.
Probability Management.
Towards a Cure for the Flaw of Averages.
The End of Statistics As You Were Taught It.
The 19th century statisticians confirmed their theories by simulating uncertainty with dice, cards and marked balls. Today, computerized dice, cards and balls are bypassing the very theories they were trying to confirm.
Visualization.
Visual Statistics provides a window into distributions. You need to see it to appreciate it.
Interactive Simulation: A New Light Bulb.
Imagine simulating 100,000 rolls of a die before your finger leaves the key. A new technology does for probability distributions what the spreadsheet did for numbers.
Scenario Libraries: The Power Grid.
New data structures allow the results of simulations to be added together like numbers, providing a more practical approach to enterprise wide risk models.
The Fundamental Identity of SLURP Algebra.
This looks like math. Feel free to skip it.
The Third Generation: Distribution Strings.
Perhaps the most important outcome of Probability Management is new way of storing probability distributions in the single cell of a spreadsheet.
The Chief Probability Officer.
The CPO must strike the correct balance between transparency of presentation, data collection, and statistical rigor.
A Posthumous Visit By My Father.
Some comments from the hereafter.
Red Word Glossary
Notes
About the Author
Index
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The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty

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