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

PART 5

THE FLAW OF AVERAGES IN FINANCE

In the early 1950s the Portfolio Theory of Harry Markowitz revolutionized the field of finance by explicitly recognizing what I refer to as the Weak Form of the Flaw of Averages. Specifically, the average return is not enough to describe an investment; you also need to know its risk. This work was extended and brought into widespread practice by William Sharpe in the 1960s. Soon modern portfolio theory was broadly acknowledged in the investment community, and Markowitz and Sharpe received the Nobel Prize in 1990.

The option pricing models of Fischer Black, Myron Scholes, and Robert Merton, introduced in the early 1970s, illuminated a special case of the Strong Form of the Flaw of Averages. Specifically, the average payoff of a stock option is not the payoff given the average value of the underlying stock. Their improved modeling of this situation led to tremendous growth in the area of financial derivatives, and option theory resulted in its own Nobel Prize in 1997.

These modern-day pioneers began to make the field of finance compliant with the Flaw of Averages. By understanding their work, we may attempt to generalize these principles to other areas of business, government, and military planning that are still average-centric.