Bringing probabilities into planning and decision making.

• Author: Kavanagh, Shayne C.

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In today's environment of economic volatility and uncertainty, finance officers are facing new challenges in assessing risk and communicating financial information. For example, presenting a forecast as a single point estimate may imply an unrealistic level of precision to the audience. The Flaw of Averages advances the premise that commonly used measures of central tendency or averages (e.g., means, medians) obscure variation in the underlying data. For example, in a room full of people that includes Bill Gates, the average person is a millionaire. In environments of volatility and extremes, averages can misrepresent the true situation and lead to poor decisions. When applying financial data to plan or assess risk, this kind of misrepresentation can be potentially catastrophic. Hence, Savage believes that an approach is needed to connect financial models to probabilities to better ascertain the impact of uncertainties on an organization. For example, a "forecast" point estimate number is really an average that may hide important potential variation. Hence, the forecast is almost always wrong, and sometimes spectacularly so--not because the forecasters are bad, but because the information is not presented or considered in the right way. The model Savage puts forward for presenting and thinking about data probabilistically is called probability management.

THINKING PROBABILISTICALLY

The intent of the Flaw of Averages is to help the reader get started with thinking probabilistically. The book is built around five tools and concepts to help the mind get a handle on uncertainty.

Distinguish between Uncertainty and Risk. Uncertainty is the extent which one does not know the potential outcome or actual value of a variable. Risk is something different. First, risk is in the eye of the beholder. Two people might view the risk associated with a given uncertainty differently. For instance, two people might have very different willingness to bet on a given throw of the dice in a game of craps, even though they face exactly the same odds--these two people view the risk of loss from the game differently and have different attitudes about incurring risk in the pursuit of reward. This leads to a second important point: Risk reflects how uncertain outcomes cause loss or injury to a particular individual or group. Risk is not a synonym for uncertainty, nor does it include possible positive outcomes from an uncertainty.

An Uncertain...