In the rapidly changing field of finance, where emotions sometimes outweigh rationality, base rate investment provides a fresh viewpoint. This method, based on the notion of the ‘base rate fallacy’, enables investors to make judgments based on broad knowledge, minimizing the potential risks of responding to particular short-term influencing information.
Let us first try to understand what is known as ‘Base rate fallacy’. The base rate fallacy is a type of cognitive bias that happens when people either overestimate or completely disregard information regarding the likelihood of an event happening in favour of information that is unrelated to the result. This bias causes people to make irrational and contradictory conclusions. Consider flipping a coin. You notice three heads in a line. What is the likelihood of the following flip being heads again? Many people would predict a high probability of heads again based on the recent run. However, logic says that each flip is unrelated; therefore the base rate of heads remains a probability of 50% only. Thus, the base rate fallacy prioritizes recent, specific information above the general underpinning possibility of the event.
The base rate fallacy is a typical phenomenon in behavioural finance, in which investors make poor investment decisions and suffer significant losses.
In the stock market, the base rate fallacy presents itself in numerous ways, such as:
- Overreacting to specific news – A superb earnings announcement might cause a stock to skyrocket, but is this a one-time occurrence or a long-term trend? Base rate investment takes into account the company’s past performance, market dynamics, and general economic conditions to present a more balanced perspective.
- Fear of missing out (FOMO) might drive investors to buy expensive equities based on recent buzz. Base rate investing focuses on long-term characteristics and valuation criteria to discover stocks with a better likelihood of success.
- Investors may overlook undervalued companies due to temporary hurdles, which can be improper. Base rate investment encourages investors to look past short-term noise and evaluate a company’s long-term prospects based on its fundamentals and competitive position.
A dedicated long-term investor should strive to disregard this fallacy and focus on firms that are poised for long-term growth, which may last for decades. This method by long-term investors is known as ‘Base rate investing’, and many renowned investors throughout the world, including Warren Buffett, use it in their investment approach.
