Here, There Be Dragons: Considering the Right Tail in Risk Management
Journal of Cost Analysis and Parametrics
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.
Christian B. Smart, Ph.D., is the Director of Cost Estimating and Analysis for the Missile Defense Agency. In this capacity, he is responsible for overseeing all cost estimating activities developed and produced by the agency, and directs the work of 100 cost analysts. Prior to joining MDA, Dr. Smart worked as a senior parametric cost analyst and program manager with Science Applications International Corporation. An experienced estimator and analyst, he was responsible for risk analysis and cost integration for NASA’s Ares launch vehicles. Dr. Smart spent several years overseeing improvements and updates to the NASA/Air Force Cost Model and has developed numerous cost models and techniques that are used by Goddard Space Flight Center, Marshall Space Flight Center, and NASA HQ. In 2010, he received an Exceptional Public Service Medal from NASA for his contributions to the Ares I Joint Cost Schedule Conﬁdence Level Analysis and his support for the Human Space Flight Review Panel led by Norm Augustine. He was awarded best of conference paper at the 2008 Annual Joint ISPA-SCEA Conference in Noordwijk for “The Fractal Geometry of Cost Risk,” best of conference paper at the 2009 Annual Joint ISPA-SCEA Conference in St. Louis for “The Portfolio Effect and the Free Lunch,” best of conference paper at the 2010 Annual Joint ISPA-SCEA Conference in San Diego for “Here, There Be Dragons: Considering the Right Tail in Risk Management,” and best of conference paper at the 2011 Annual Joint ISPA-SCEA Conference in Albuquerque for “Covered with Oil: Incorporating Realism in Cost Risk Analysis.” Dr. Smart was named the 2009 Parametrician of the Year by ISPA. He is a SCEA certiﬁed cost estimator/analyst (CCEATM), a member of the Society of Cost Estimating and Analysis (SCEA) and the International Society of Parametric Analysts (ISPA) (ISPA and SCEA are now merged and have become ICEAA). Dr. Smart is a past president of the Greater Alabama Chapter of SCEA, is the managing editor for The Journal of Cost Analysis and Parametrics, and served as the Region III VP on the SCEA national board of directors prior to the ISPA SCEA merger. Dr. Smart earned bachelors degrees in Economics and Mathematics from Jacksonville State University, and a Ph.D. in Applied Mathematics from the University of Alabama in Huntsville.