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

Book 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 forThe 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

Table of Contents

  1. Title Page
  2. Copyright Page
  3. Dedication
  4. Preface
  5. Acknowledgements
  6. Introduction
    1. Foundations
    2. Applications
    3. Probability Management
  7. PART 1 - THE BIG PICTURE
    1. CHAPTER 1 - The Flaw of Averages
      1. Give Me a Number
      2. Statisticians to the Rescue?
      3. Red Lobster
      4. Red River
      5. Red Ink in Orange County
      6. The Red Coats
      7. Why Forecasts Are Always Wrong: A Problem of Dilbertian Proportion
    2. CHAPTER 2 - The Fall of the Algebraic Curtain and Rise of the Flaw of Averages
      1. Becoming a Management Scientist
      2. Abandoning Management Science
      3. Being Reborn as a Management Scientist
      4. On the Road Again
      5. From OR to PR and Back
    3. CHAPTER 3 - Mitigating the Flaw of Averages
      1. Probability Management
      2. Doing for Probability What Edison Did for Electricity
      3. The Consolidated Risk Statement
    4. CHAPTER 4 - The Wright Brothers Versus the Wrong Brothers
      1. A Wind Tunnel for Your Business Plan
    5. CHAPTER 5 - The Most Important Instrument in the Cockpit
      1. Learning About Learning
      2. Flying on Instruments: When Gut Instinct Isn’t Enough
  8. PART 2 - FIVE BASIC MINDLES FOR UNCERTAINTY
    1. CHAPTER 6 - MINDles Are to MINDs What HANDles Are to HANDs
      1. Steam Era Statistics: Things to Forget
    2. CHAPTER 7 - Mindle 1: Uncertainty Versus Risk
      1. Risk Is in the Eye of the Beholder
    3. CHAPTER 8 - Mindle 2: An Uncertain Number Is a Shape
      1. New Brunswick Hold ’Em
      2. Uncertain Numbers: The Shape of Things to Come
      3. The Weak Form of the Flaw of Averages
      4. Give Me a Distribution
      5. Black Swans
      6. Some More Stuff on Distributions
    4. CHAPTER 9 - Mindle 3: Combinations of Uncertain Numbers
      1. A Portfolio of Spinners
      2. So What?
      3. Diversification: A Green Word for the CENTRAL LIMIT THEOREM
      4. You Don’t Need to Know
      5. The Power of Diversification
      6. Poster Child for the CENTRAL LIMIT THEOREM
    5. CHAPTER 10 - I Come to Bury SIGMA, Not to Praise it
      1. Outputs of Simulations
      2. Definition of SIGMA
    6. CHAPTER 11 CHAPTER - Mindle 4: Terri Dial and the Drunk in the Road
      1. The Strong Form Versus the Weak Form
      2. It’s Too Hard to Change the Way People Do Business
      3. Tugging at the Distribution
      4. Evaluation of a Gas Well
      5. The Cyclone Hits London
      6. The Human Cyclone Meets the Financial Tsunami
    7. CHAPTER 12 - Who Was Jensen and Why Wasn’t He Equal?
      1. Spreadsheets with Uncertain Inputs
      2. Options, Restrictions, Smiles, and Frowns
    8. CHAPTER 13 - Mindle 5: Interrelated Uncertainties
      1. COVARIANCE and CORRELATION are Red Words
      2. Three Idealized Investments
      3. Portfolios
      4. Three Idealized Portfolios
      5. A Mindle for Interrelated Uncertainties: The Scatter Plot
      6. CORRELATE This!
  9. PART 3 - DECISIONS AND INFORMATION
    1. CHAPTER 14 - Decision Trees
      1. Decision Trees
      2. Giving Back
    2. CHAPTER 15 - The Value of Information
      1. The Complement of Uncertainty
      2. What’s It Worth to You?
      3. A Military Example
      4. The Value of Obfuscation
      5. Prototyping
  10. PART 4 - THE SEVEN DEADLY SINS OF AVERAGING
    1. CHAPTER 16 - The Seven Deadly Sins of Averaging
      1. The List
    2. CHAPTER 17 - The Flaw of Extremes
      1. Sandbagging
      2. Layers of Fat
      3. Howard Wainer’s Most Dangerous Equation
    3. CHAPTER 18 - Simpson’s Paradox
      1. Kidney Stones
      2. Baseball
    4. CHAPTER 19 - The Scholtes Revenue Fallacy
      1. Economics 101
    5. CHAPTER 20 - Taking Credit for Chance Occurrences
      1. Advertising Results
      2. Pharmaceutical Effectiveness
      3. An Age-Old Scam
  11. PART 5 - THE FLAW OF AVERAGES IN FINANCE
    1. CHAPTER 21 - Your Retirement Portfolio
      1. Simulation for the Masses
      2. Smoothing Things Out
    2. CHAPTER 22 - The Birth of Portfolio Theory: The Age of Covariance
      1. Risk Is the New Dimension
    3. CHAPTER 23 - When Harry Met Bill(y)
      1. A Simplified Model of the Relationships Among Securities
      2. All Models Are Wrong
    4. CHAPTER 24 - Mindles for the Financial Planning Client
      1. Bessemer Trust
      2. Interactive Simulation at Bessemer
      3. Financial Engines
    5. CHAPTER 25 - Options: Profiting from Uncertainty
      1. Stock Options
      2. Implied Volatility, the Uncertainty Gauge
    6. CHAPTER 26 - When Fischer and Myron Met Bob: Option Theory
      1. Risk-Neutral Pricing
      2. Publication
      3. Long-Term Capital Management: The Perfect Storm
      4. Skin in the Game
    7. CHAPTER 27 - Prices, Probabilities, and Predictions
      1. Futures and Probabilities
      2. Options and Uncertainty
      3. Prediction Markets
      4. Predicting Terror Attacks
      5. DARPA Gets into and out of the Picture
      6. Predictomania
      7. When Does This Stuff Work?
  12. PART 6 - REAL FINANCE
    1. CHAPTER 28 - Holistic Versus Hole-istic
      1. A Serendipitous Sequence of Events
      2. We Win Some and Lose Some
      3. Our Ideas See the Light of Day
      4. The Decision Forest
    2. CHAPTER 29 - Real Portfolios at Shell
      1. The Planets Were Aligned
      2. The Model Survives a Hurricane and Management Changes
    3. CHAPTER 30 - Real Options
      1. Keeping Sailplanes Aloft
      2. Case Study: Restoring a ’64 Porsche
      3. Supplying Thrust in Podunk
      4. Meanwhile Back at Wells Fargo
    4. CHAPTER 31 - Some Gratuitous Inflammatory Remarks on the Accounting Industry
      1. FASB and the Weak Form of the Flaw of Averages
      2. FASB and the Strong Form of the Flaw of Averages
      3. Some Constructive Criticism for the Accounting Industry
  13. PART 7 - THE FLAW OF AVERAGES IN SUPPLY CHAINS
    1. CHAPTER 32 - The DNA of Supply Chains
      1. Just Plain Nuts
      2. When Less Is More
      3. The Bullwhip Effect
      4. The Beer Game
    2. CHAPTER 33 - A Supply Chain of DNA
      1. A Supply Chain at Genentech
      2. Forecasting Done Right
      3. An Interactive Dashboard
    3. CHAPTER 34 - Cawlfield’s Principle
      1. From Remedial Math to Chemical Engineer
      2. A Problem at Olin
      3. The General Principle
  14. PART 8 - THE FLAW OF AVERAGES AND SOME HOT BUTTON ISSUES
    1. CHAPTER 35 - The Statistical Research Group of World War II
      1. German Tanks
      2. Protective Armor on Bombers
      3. Half a Battleship
    2. CHAPTER 36 - Probability and the War on Terror
      1. The Magic Bullet
      2. The False Positive Problem
      3. There Is Nothing to Cheer but Fear Itself
      4. Rumsfeld Asks the Right Question
    3. CHAPTER 37 - The Flaw of Averages and Climate Change
      1. Why the Earth’s Average Temperature Is Falling
      2. The Bad News
      3. The Good News
      4. Free Markets and the Tragedy of the Commons
      5. Learning the Controls
    4. CHAPTER 38 - The Flaw of Averages in Health Care
      1. Treating the Average Patient
      2. Medicine Meets Mathematics
      3. Unintended Consequences
      4. I’m Not Dead
    5. CHAPTER 39 - Sex and the Central Limit Theorem
      1. The Results of Diversifying Your Portfolio of X Chromosomes
      2. Which Tail Are You Looking At?
      3. The Myth of the Myth of the Math Gender Gap
      4. On Rethinking Eugenics
  15. PART 9 - TOWARD A CURE FOR THE FLAW OF AVERAGES
    1. CHAPTER 40 - The End of Statistics as You Were Taught It
      1. Galton’s Dice
      2. The Bad Boys of Statistics
    2. CHAPTER 41 - Visualization
      1. Visual Statistics
      2. Toward a Theory of Irrational Expectation
    3. CHAPTER 42 - Interactive Simulation: A New Lightbulb
      1. The Return of a Pioneer
      2. Polymorphic
      3. Tip of the Iceberg
    4. CHAPTER 43 - Scenario Libraries: The Power Grid
      1. Modular Risk Models and Age of the Scatter Plot
      2. The Subprime Mortgage Fiasco
    5. CHAPTER 44 - The Fundamental Identity of SLURP Algebra
    6. CHAPTER 45 - Putting It into Practice
      1. The DIST Distribution String
      2. Certification and Auditing
      3. Software Implementation
      4. The Outlook
    7. CHAPTER 46 - The CPO: Managing Probability Management
      1. The CPO Versus the CRO
      2. In the Land of the Averages, the Man with the Wrong Distribution Is King
      3. Probability Management at Merck & Co.
      4. Calibrating Your CPO
      5. To Blow or Not to Blow the Whistle, That Is the Question
    8. CHAPTER 47 - A Posthumous Visit by My Father
  16. Red Word Glossary
  17. Notes
  18. About the Author
  19. Index