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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:
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 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. Let’s have a look at some of these consequences below.
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.
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.
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:
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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