Base Rate Fallacy
The human mind is riddled with several fallacies. When human beings make investment decisions, they are battling a wide variety of biases.
In this module, we have discussed a lot of these biases. The base rate fallacy is another important bias that directly and profoundly impacts the investors decision-making process. The base rate fallacy is actually more complex as compared to other fallacies.
This is the reason that this fallacy may be difficult to understand. The explanation has been provided below:
What is Base Rate Fallacy?
The base rate fallacy is the tendency of human beings to prefer one set of the information above the other. For instance, when making a financial decision, investors receive different information at different points in time. Because of the base rate fallacy, investors tend to ignore important information and end up basing their decisions on irrelevant information.
The root cause of the base rate fallacy is the inability to distinguish between information that may be relevant and information that may not be! This inability is usually the result of an incorrect belief.
For some reason, the investor may believe that the statistical information does not apply to them and hence may end up basing their information on a wrong set of data.
This fallacy was discovered by Nobel Prize-winning psychologists Kahneman and Tversky, who are already quite well known in the field of behavioral finance for their contributions.
The Different Types of Information
The base rate fallacy assumes that investors receive different types of information about an investment over a period of time. If the content of both the information is the same, then the multiplicity of the sources does not make a big difference.
However, if the content is different, then the investor has to make a choice. This is where there is a possibility that they may make a mistake by basing their decision on the wrong source of information.
In order to understand the fallacy, we must understand the different sources of information. There is information built about every investment over the years.
For instance, when investors invest in a company, there is historical information that sets a precedent for future predictions. This historical information is based on statistical and empirical evidence and hence is often referred to as the base rate. On the other hand, we have some recent information coming in.
For instance, the company may provide a quarterly result, which may have completely deviated from the predictions. In this case, this information is event-specific information. This fall in quarterly earnings may have been a one-time event that was triggered by external factors.
In this case, the investor is facing a dilemma as there is a difference between the historical information, i.e., the base rate and the event specific information.
Most investors tend to ignore the historical aspect and make decisions based on new information. This is because they often believe the new information to be more updated and hence falsely believe that statistical data has now become irrelevant.
Obviously, this may lead to negative financial consequences. Lets have a look at some of these consequences below.
Consequences of the Base Rate Fallacy
- The most obvious side effect of the base rate fallacy is an overreaction to certain market events. People prone to base rate fallacy are the ones who make quick buy and sell decisions based on recent events.
Hence, being prone to the base rate fallacy means that trading happens more excessively than it should. Traditional financial theories assume that new information is immediately reflected accurately in the price of the security.
However, in most cases, people tend to overreact, and the price swings more in the opposite direction than it should. These surges are not permanent, and over time these changes are eroded.
- Investors with base rate fallacies tend to suffer losses because of their hasty decision making. However, since they lose money, they tend to become disenchanted with the investment process itself.
Several investors with base rate fallacy have reported reducing their investments in the market. The end result of the base rate fallacy often is that investors tend to invest more in debt products even though they should ideally be taking more risks.
How to Avoid the Base Rate Fallacy?
The root of the base rate fallacy is the tendency of the investor to make extremely quick decisions. This can be avoided using the following measures:
- Avoid making decisions based on recent events alone. It is important to put the recent events from a long-term perspective and to analyze them before decisions are made.
- Avoid making all decisions by yourself. Hire the services of a trusted and unbiased advisor and then discuss your decision with them before actually executing your decision
- Avoid investing with a short term mind-sets. When investors make investments for a period of time spanning decades, then the smaller events seem to be what they really are, a small blip in the larger scheme of things.
The bottom line is that base rate neglect can unwittingly creep into our thinking. As an informed investor, we need to take steps to ensure that this behavior does not induce us to make short-sighted decisions and incur losses in the long run.
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Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Behavioral Finance - An Introduction
- Heuristics and their role in Finance
- Advantages of Behavioral Finance
- Limitations of Behavioral Finance
- FAQs About Behavioral Finance
- Prospect Theory
- How Loss Aversion Affects Investment Decisions
- The Sunk Cost Fallacy
- The Endowment Effect
- Regret Aversion Bias
- Self-Control Bias
- Anchoring Bias in Behavioural Finance
- Confirmation Bias in Behavioral Finance
- Herd Mentality Bias
- Mental Accounting
- Recency Bias
- Overconfidence Bias
- Conservatism Bias
- Framing Bias
- Behavioral Portfolios
- Hindsight Bias
- Illusion of Control Bias
- Status Quo Bias
- Sample Size Neglect
- Optimism Bias
- Cognitive Dissonance Bias
- Home Country Bias
- Availability Bias in Behavioural Investing
- The Bias Blind Spot
- The Narrative Fallacy
- The Planning Fallacy
- Base Rate Fallacy
- Contrarian Investing
- Cultural Influences on Financial Decisions
- Behavioral Life Cycle Theory
- The Barnewall Model
- Bielard, Biel and Kaiser (BBK) Model
- Three Dimensional Pscychographic Model
- Categorizing Behavioral Biases
- Lessons Learned in Behavioural Finance