You love to smoke and when someone points out its harmful effects, you say that my grandpa used to smoke a pack a day and he still lived to be 98.
You also don’t like to wear seatbelts when driving and you repeat the same story that your grandpa in his times didn’t even have seatbelts and yet he drove like a Schumacher.
These are both examples of accepting the romantic over logic. That is the base rate fallacy. To justify our reasoning of whatever we are trying to reason with, we accept stories over prevailing data.
The base rate is the statistical frequency of the likelihood of an event. For example, if 1% of the population has a certain disease, that 1% is the base rate. When evaluating if someone has the disease, this base rate is important in evaluating any test results because if the disease is very uncommon, the test result might still be wrong even if the test is usually accurate.
The fallacy occurs when we ignore general statistical information and focus only on specific details. This often leads to wrong conclusions because we forget how common or rare something actually is.
What causes the base rate fallacy? We find stories more interesting and easier to remember than numbers or statistics. Our brains like to match patterns and make quick judgements even if those judgements skip important background information.
So never go to a casino to play blackjack thinking you’ll win against the casino. They set the base rates in their favor because they (the casinos) are not in the business of losing money. Play there long enough and you are guaranteed to lose.
Same story when playing the lottery.
About the lottery, we are all starry-eyed when looking at how rich you’d be if you bought Nvidia or Vulcan Materials or Kansas City Southern shares. What? Nvidia you have heard off but bet you never heard of Vulcan Materials or Kansas City Southern, a few of the best performing stocks these past 100 years. And the list of best performing stocks does not run very long.
In fact, getting rich off of owning a few stocks is so rare, not just in coming across them but then holding on to them through their expected gigantic ups and downs that you are better off thinking of them like playing the lottery.
And it is like playing the lottery because the base rates of winning by owning individual stocks are unfavorable enough that you may not want to try except as a way of trying out your luck.
Though not quite a statistical argument, the interest rate on a 10-year Treasury bond is the base rate you’d want to evaluate all investments off of. The duration is comparable enough to any long-term investment you’d make.
So if the 10-year Treasury bond is yielding 5 percent and you come across an investment that yields 7 percent, there is going to be some risk.
But when someone pitches a can’t lose investment with returns far, far higher than what a Treasury bond yields, you know you are going to be taken because you know the base rate of what a safe investment, backed by a government guarantee, yields.
But base rates are often overlooked and you don’t have to look hard to find stories about slick salespeople enticing you to overlook them because, well, they are in the business of scam.
To induce his victims to invest their money with him, Lickiss claimed he had exclusive access to fictitious bonds that paid very high rates of returns, including rates in excess of 20 percent. Lickiss described the fictitious bonds as safe, secure, and tax-free, and falsely claimed, among other things, that they could be redeemed at any time.
Former East Bay Financial Advisor Charged With Allegedly Operating Long-Running $9.5 Million Ponzi Scheme
Dougherty offered clients the opportunity to invest in tax-free “private placements” that purportedly provided quarterly dividends of about 5%. The complaint alleges that, in reality, there were no private placements. Dougherty was simply running a Ponzi scheme by taking new investor money and using it to pay quarterly dividends to existing investors and his personal expenses.
SEC Charges San Diego-Based Investment Adviser with Running a Ponzi Scheme
The consequences for you though in ignoring base rates are often brutal as you’ll seldom see your money back.
Don’t be the victim. Probability and averages matter. Base rates matter. Use them as a baseline when making good investing decisions.
Thank you for your time.
Cover image credit – David McEachan