Here, There Be Dragons: Considering the Right Tail in Risk Management

Abstract

The “portfolio effect” is a common designation of a supposed reduction of cost risk achieved by funding multiple projects (the “portfolio”) that are not perfectly correlated with one another. It is often relied upon in setting confidence-level policy for program or organization budgets that are intended to fund multiple projects. The idea of a portfolio effect has its roots in modern finance, as pioneered by 1990 Nobel Memorial Prize in Economic Sciences recipient Harry Markowitz (1959). On the other hand, in presentations to four recent ISPA-SCEA conferences, 2007–2010, the present author argued that, when applied to Government budgeting, the portfolio effect is more myth than fact. However, current National Aeronautics and Space Administration and Department of Defense policy guidance relies heavily upon this apparently chimerical effect. The objective of the present article is to propose a superior alternative budgeting decision process based on a concept called “conditional tail expectation” that better measures project risk exposure in terms of the project's expected shortfall in funding. Also called “tail value at risk,” use of this risk-assessment technique is growing in popularity in a variety of financial contexts, including insurance.