The Flaw of Averages

Although understood by mathematicians & statisticians for

centuries, the Flaw of Averages was named by Sam Savage,
currently a Consulting Professor at Stanford University. To
paraphrase Sam,
An estimate based on the assumption that average
conditions will occur will almost always be wrong (with
there usually being no way to determine ahead of time
whether the estimate will be optimistic or pessimistic).
For this portion of the session, the learning objectives are:
Learn why managers should confront and communicate uncertainties instead of
ignoring them.
Learn how a manager can get into trouble by not understanding The Flaw of
Averages.

Statistician Drowns in River with Average Depth of 3 Feet!

Statistician is Comfortable on Average!

A statistician has is his head in a _________
and his feet in a ________.
When asked how he feels, he says,
On average, I feel comfortable.

Example 1 -- Optimistic
This weeks demand for an item is estimated to be one of 6 equally-likely values:
5000, 7000, 9000, 11,000, 13,000, or 15,000 units.
The items unit selling price is $9 and unit production cost is $6.
As CFO, you have been informed that this weeks production quantity will be 10,000
and have been asked to provide a SINGLE NUMBER as the estimate for this weeks
contribution to profit and overhead; that is, you have been asked to estimate the
average contribution to profit and overhead.
What is your estimate?

Units Sold =
Revenue from Sales =
Cost of Production =
Contribution to Profit & Overhead =
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Example 1 (continued)
An estimate of ($9-$6)(10,000) = $30,000 is incorrect because it is based on the
Flaw of Averages (FofA). To understand the flaw, consider the following table
(keeping in mind that the production quantity is fixed at 10,000):

Whereas FofA estimates average Contribution as $30,000, the actual average is:

FofA results in a very OPTIMISTIC estimate, overestimating the actual average by

(30,000 16,500)
82%
16,500
The optimism results because FofA counts upside even though it will never occur.
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Instead of $30,000 being the AVERAGE Contribution, it is the MAXIMUM!

Example 2 -- Pessimistic
Your firm has purchased for $1 a (European) call option on a stock with a exercise
date of one week from today and an exercise price of $18; that is, for $1, you have
purchased the guaranteed right to sell the stock one week from today at $18.
The price per share of the stock one week from today is estimated to be one of 6
equally-likely values:
$15, $17, $19, $21, $23, or $25.
As CFO, you have been asked to provide a SINGLE NUMBER as the estimate for
options value; that is, you have been asked to estimate the options average value.
What is your estimate?

Stocks Price (one week from today) =

Options Payoff =
Options Cost =
Options Net Value =
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Example 2 (continued)
An estimate of ($20-$18)-$1 = $1 is incorrect because it is based on the Flaw of
Averages (FofA). To understand the flaw, consider the following table (keeping in
mind that the options exercise price is $18):

Whereas FofA estimates the options average value as $1, the actual average is:

FofA results in a very PESSIMISTIC estimate, underestimating the actual average by

(1.67 1)
40%
1.67
The pessimism results because FofA counts downside even though it will never
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occur.

Review of Terminology and Notation

A random variable X is a value about which we are uncertain.

The following are equivalent ways of referring to the same thing:

The mean of X, denoted by X.
The expected value of X, denoted by E[X].
The (weighted) average value of X, denoted by X

Example 3 -- with Two Random Variables

Jeff and Jackie are analysts for J&J Industries. They have been asked to forecast the average
daily sales (S) for a product with both uncertain daily production (P) and uncertain daily
demand (D). The tables below summarize this uncertainty, where it assumed that P & D are
independent random variables.

PRODUCTION
P

DEMAND
D

Value

Prob

Value

Prob

80

0.25

96

0.50

100

0.50

120

0.25

112

0.50

100 = Mean

104 = Mean

Jeff and Jackie note that:

If, for example, P=100 & D=112, then S=100.
If, for example, P=100 & D=96, then S=96.
In general, for a given P & D, S = min(P,D).
So, Jeffs and Jackies goal is to forecast the mean of min(P,D).

Value

Prob

Value

Prob

80

0.25

96

0.50

100

0.50

112

0.50

120

0.25

104 = Mean

100 = Mean
To forecast the mean of min(P,D), Jeff notes that Mean of P = 100 and Mean of D = 104 and
concludes that
Mean of min(P,D) = min(Mean of P, Mean of D) = min(100,104) = 100.
However, Jackie disapproves of Jeffs approach. To forecast the mean of min(P,D), Jackie
uses the following tabular approach:
P

Joint Prob

min(P,D)

(Prob)*min(P,D)

80

96

0.125

80

10

80

112

0.125

80

10

100

96

0.250

96

24

100

112

0.250

100

25

120

96

0.125

96

12

120

112

0.125

112

14

Mean = Column Sum = 95

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Whose forecast of sales is correct -- Jeffs forecast of 100 or

Jackies forecast of 95?
Jackie is correct, since she computed the mean of min(P,D) from first principles,
whereas
Jeff is incorrect, because he incorrectly assumed that
Mean of min(P,D) = min(Mean of P, Mean of D)
Jeffs error illustrates the so-called

FLAW OF AVERAGES
In general, if X1, X2, , Xn are random variables, and f(X1, X2, , Xn) is a function of
these n random variables, then
does NOT equal

Mean of f ( X 1 , X 2 , , X n )

f (Mean of X 1 , Mean of X 2 , , Mean of X n )

In words instead of symbols, the Flaw of Averages states that the mean of a
function of random variables does not equal the function of the means of the
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random variables.

In performing an analysis, instead of directly confronting uncertainty, many

managers hide from uncertainty by using the mean of a random variable
as a proxy for the random variables probability distribution.
Because of the Flaw of Averages, hiding from uncertainty almost always
results in incorrect results.
In our baby example,
Jeffs hiding from uncertainty resulted in an incorrect forecast of 100,
whereas
Jackies confronting uncertainty resulted in a correct forecast of 95.

So, even in our baby example, the forecast error for Jeff was

100 95
95

0.0526 5.26%

As we will see, Simulation enables us to confront and communicate

uncertainty instead of hiding from it. In particular, the software Crystal
Ball enables simulation within an Excel spreadsheet.
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