Behavioral finance FAQ / Glossary (Base rate)

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Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

Base rate fallacy / neglect



07/2i + see representativeness
heuristic, probability, mental
account, optimism, illusion,
overconfidence

When impressions or legends are taken

as statistical truths and decision-making criteria.

Definition: the base rate fallacy / neglect is a rather common mistake (*) done by
people who, when making decisions:

(Base rate neglect) Ignore or forget the past statistical
    frequency of events,

(Base rate fallacy) And/or use wrong information or subjective
   
impressions / estimates about that frequency..

(*) This cognitive bias belongs to the "representativeness heuristic" (see
      that
phrase) category.

The consequences

Fancy probabilities bring amateurish decisions

When this neglect distorts its analysis and decision-making abilities, it
can lead a person (or a group, committee...) to:

Overestimate or underestimate widely an event probability.

For example people often

* overestimate low probabilities
* and underestimate high ones.

=> Some might see 5% as one third and 95% as two thirds

This is a kind of mental anchoring on some illusive "middle
of the road" frequency
of some event, even when it is scarcer
or more frequent.

Reality is usually much more asymmetric than a
50/50 "heads  or tails".

There is not specific reason that:

An event, for example breaking a leg when falling,

happens in a systematic way 50% of the time,

And all other events (breaking your neck, breaking an arm,

 breaking nothing...) the other 50%.

Or that among 5 possible events each one has a 20 %
    probability to happen.


 Also people who take an initiative are often overconfident in
 their ability
, and overoptimist about the project prospects
 compared to its risks and difficulty, and they neglect to get
 informed on the rate of success of comparable ventures in the
 past


But at the same time exclude the idea that
   very rare events
(see "small numbers") might
    suddenly happen.

The opposite bias

Numbers' fan club

Of course, the opposite attitude (see "numeracy bias"), a blind veneration
for past
statistics and mathematical theories, as tools to predict the future,
is also a mental limitation.

To cling to previous data might make forget the context, the
surrounding situation and the potential evolutions (or
even disruptions) that might contradict the past.

It can be laudable to stuff models with algorithms that are supposed to
spot in an automatic mode (rightly or wrongly, just in time or not), the most
probable future market orientations, such as the persistence of a trend or
even the birth of a new one .

But in many areas, notably human and social ones, uncertainty (see that
word) can override known probabilities and smart equations.

Even so, to neglect or to be wary about past numbers should not
leadto wild and uneducated beliefs.

Pure "flair" and "instinct", when it implies to deny
known records, also has its dangers.

Following his / her own nose should not give the nose's owner an
illusion of certainty.

=> It should only induce to think about a range of

possible alternative scenarios (see scenarios, range aversion...).

How this fallacy can strike investors

Rating performances with rosy or dark glasses

In asset markets, this cognitive bias can make investors
under- or over-estimate:

Either their own past or future performance,

Or a money manager past or future performance,

Or the general market past or future performance.

This ignorance of the real records by investors can
distort their vision of potential future outcomes and
make them overoptimistic or over-pessimistic.

Other information neglects, for example to forget to take
costs and inflation into account
to weigh the real
performances (see mental accounts), can compound the
mistake.

(*) To find those messages: reach that BF group and, once there,
      1) click "messages", 2) enter your query in "search archives".

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This page last update: 17/07/15   

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