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

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Overview

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 ...

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Overview

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.

Product Details

  • ISBN-13: 9780471381976
  • Publisher: Wiley, John & Sons, Incorporated
  • Publication date: 6/9/2009
  • Edition number: 1
  • Pages: 416
  • Sales rank: 353,290
  • Product dimensions: 6.20 (w) x 9.10 (h) x 1.50 (d)

Meet the Author

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.

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 MINDIes for Uncertainty 45

Chapter 6 MINDIes Are to MINDs What HANDIes 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

The Nuts and Bolts of the Strong Form of the Flaw of Averages

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

Because There Isn't Anything Else

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 Client175

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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  • Anonymous

    Posted May 28, 2010

    You'll Never Look At Statistics The Same Way Again

    The Flaw of Averages was a fun read - something that many people probably thought couldn't be said about a book on risk management and statistics. Savage's writing style makes the subject matter approachable and understandable. As he himself notes, he'd been working on this book for years, and some who read this will wonder what their financial position might have been had he published it before the financial market collapse of several years ago. Of course, there are also those in the oil and gas industry who might wish they'd read the book even two months ago...

    Was this review helpful? Yes  No   Report this review
  • Anonymous

    Posted May 22, 2012

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