Magazine article Risk Management

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

Magazine article Risk Management

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

Article excerpt

THE FLAW OF AVERAGES: WHY WE UNDERESTIMATE RISK IN THE FACE OF UNCERTAINTY

BY SAM L. SAVAGE

[ILLUSTRATION OMITTED]

"Consider a drunk staggering down the middle of a busy highway and assume that his average position is the centerline. Then the state of the drunk at his average position is alive, but on average he's dead."

This example, in a nutshell, illustrates the "flaw of averages." It is a concept that explains why many business plans end up below projection, behind schedule and beyond budget. It even explains the subprime mortgage crisis and has implications for the war on terror, climate change and the difference between the sexes.

The idea is simple. As author Sam Savage puts it, "Plans based on average assumptions are wrong on average." The problem is not that we calculate averages incorrectly, but that we assign the incorrect meaning to the result. …

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