Ask Question Asked 6 years, 3 months ... ("prevalence" or base rate probability). Impact on Intrusion Detection Systems 5. You could if you wished simply buy the sector in toto by using a collective or by buying a basket of shares. 2.1 The base rate fallacy. One great example of the Bayes theorem and how it impacts our daily decision making is the base rate fallacy. The evidence would suggest that experts and amateurs alike are poor forecasters whether it comes to company earnings or macro events - it seems the future just isn't all that clear, whatever the scale! Bayes’ theorem states that: The above looks complicated, so let’s go back a bit. He asked his servant (in yellow) to throw a ball on the table and mark the position, where the ball has landed. Someone else who fancies themselves at stock picking would be sticking individual companies under their microscope and assessing their potential as individuals. 8.5 The Base Rate Fallacy. This is where we find out that our minds are poorly primed to deal intuitively with probabilistic reasoning. Thanks for the book recommendation, had a quick look on Amazon and it looks like an interesting read. He avoids start-ups and biotech or exploration stocks. Student of Life I cannot find any of that reflected in your discussion of John Lee's approach that will help others to emulate it. [Again I think this must improve the probability of out-performance by those stocks of the market as a whole.] I was using Lord John Lee as an example of someone who been extremely successful at investing over many years, and whose success supports what Tom Firth wrote in that section. A recent opinion piece in the New York Times introduced the idea of the “Base Rate Fallacy.”. 47.37% (90 / (90 + 100)). I think his use of the above rules over the years must have greatly improved the 'conditional probabilities' [which could, in principle, be calculated mathematically using Bayes Theorem] of him constructing portfolios of stocks that significantly out-performed the FTSE All Share index. After that, the servant threw other balls on the same table and was ask to tell Bayes, where this (second, third, fourth…) ball has fallen in relationship to the mark of the first ball. We will begin to justify this view today. Of course, John Lee's rules are not the only way to do that. Ian, I've just finished reading the book 'How to make a million - slowly' by Lord John Lee, who has been an extremely successful private investor over many years. 2 Conditional Probability. The axioms of probability are mathematical rules that probability must satisfy. Conclusion Tom, thanks for an interesting and useful article. And if you do discover that ignorance runs a little deeper than you hoped, well, then there's a hedge for that by the name of diversification. This is however much, much lower than lactose intolerance, with 0.09%. Base rate fallacy, or base rate neglect, is a cognitive error whereby too little weight is placed on the base, or original rate, of possibility (e.g., the probability of A given B). But if we do the test with 100,000 people again, we get: Due to the rare occurence of this disease the confidence in the test, even though the test is as good as the one above, goes down to less that 50%, i.e. Ultimately, most of us are in this game to protect and grow our capital...not to convince ourselves and others that we're great stock pickers! In the appendix we work a similar example. It shows how a prior assumption (called prior probability) is updated in a light of new evidence. As far as I'm concerned, whatever works, works. Bayesian inference includes conditional probability. As with the base rate fallacy, this process is best outlined with an example, for which I will use example 2 on the same Wikipedia page linked above. The structure of this problem is the same as that of the base rate fallacy. A good stock picker may be better off shorting their sectors to get the relative perf of their stock picks if they want to avoid base risk. These are most easily described and understood with an example, which I have shamelessly sourced from Wikipedia. On the other hand, with Sensitivity at 70% the probability of infection, given a negative test result, is not zero, but depends on the Base Rate. In other words, he greatly improved his 'base rate' probabilities of investing success by following those rules. That all makes sense and in particular your 3rd paragraph clarifies nicely. [Again, this reduces the chances of fraud by the management at the expense of shareholders.] Have a good evening, Base Rate Fallacy。 The Base Rate in our case is 0.001 and 0.999 probabilities. A witness claims the cab was green, however later tests show that they only correctly … [This must improve his stock-picking success rate, although it is hard to quantify this, and many private investors don't have the time to do this.]. This equation is completely fine like it this, but let me expand on P(E), the probability of seeing the evidence, a little bit more. If you will allow me to play Devil's advocate for a minute though, how would you say that picking sectors is different from picking stocks? noted that research on the "base-rate fallacy" used an incomplete Bayesian analysis. A really excellent and thought provoking piece, thank you. After having received the test result (new evidence), we can update our belief by this new evidence. Explained based on a test for a rare disease: Basically, when the percentage of people with a disease is lower than the test’s false positive rate, the chance of getting a false positive is higher than actually having the disease. This updated belief (the resulting posterior probability) incorporates all the evidence of that claim. Tom, I think your article is excellent, but it's use of the mathematical term Bayes Theorem might frighten a lot of people who are not mathematicians. I'm read Kahneman so have already grappled with Bayes Theorem and found it fascinating to see how absolutely counter intuitive the outcomes are when it's applied to apparently simple problems. 6. Base rate fallacy. Get an intuition of what Bayes theorem is: One great example of the Bayes theorem and how it impacts our daily decision making is the base rate fallacy. - He likes to invest in companies in which a number of directors are buying stocks in their own company using their own savings (as opposed to being granted options). [It is well known that 'value' stocks and stocks with high dividend yields tend as a group to out-perform over the long-run.] In other words, he greatly improved his 'base rate' probabilities of investing success by following those rules...." Why are spam filters claimed to be so accurate and yet mess up so often? We are told that if a person is actually drunk, the test will indicate so 100% of the time but, in addition to this, 5% of people tested will display a false positive – the test says they are drunk when they…. If we look at the investment process through this probabilistic lens, what can consideration of base rates and Bayes’ theorem offer us? The rate at which something happens in general is called the base rate. Base Rates and Bayes’ Theorem. My own experience is that it has several times been possible to call the oil sector and to position oneself with advantage. What I'm trying to say is that if builders or banks are in a period of decline then the answer is to avoid those sectors not to invest time and energy trying to pick the best stocks therein. might address those concerns. P( H | E ) = probability of H(ypothesis) given that E(vidence) [so “|” means “given that”] or in other words, the probability that the hypothesis holds, given that the evidence is true. From a personal perspective, I am still a little wary as I do not have full faith in my ability to reliably identify such trends in a timely manner due to my inexperience, ignorance and so on. I came across the US Guru screens on AAII whose performance data goes back 10 years or more: http://www.aaii.com/stock-screens?a=menubarHome - Click on the different year tags for % gain rankings. When evaluating the probability of an event―for instance, diagnosing a disease, there are two types of information that may be available. Thanks, I'm only about half way through but his thinking on the subject is great and has added some clarity to my own ideas about this particular tendency affects the investment process - hence the article! People tend to simply ignore the base rates, hence it is called (base rate neglect). Is it easier? P(E|H) is the probability of the evidence if the hypothesis is true. One criticism or thing to notice, is that the whole calculation is dependent on the “prior”, the starting hypothesis, that is waiting to be updated by the new evidence. Base rate fallacy/false positive paradox is derived from Bayes theorem. [I think another way to look at this rule is he is using negative momentum to make some selling decisions, and it is well known that stocks with recent negative momentum tend to under-perform the market as a whole over the short-term.] Change ), You are commenting using your Google account. In the taxicab example, the base rate for blue cabs was \(15\%\). Bayes (in green) was sitting was sitting with his back to plain table, with a book and pen. Always good to question your own stock picking skills in my view. Is it easier? The base rate fallacy is also known as base rate neglect or base rate bias. They know about it. Which might also strengthen the case for IT's or OEICs or ETF's which provide broad coverage of target sectors. We can avoid this fallacy using a fundamental law of probability, Bayes’ theorem. Pretty much any house builder you bought a few years ago would have done extremely well and if you knew the sector was undervalued, you could have saved yourself a lot of effort by just buying a basket of them. And if oil companies are in the ascendant then you can harvest much of the potential gains without succeeding in picking the very best stock. generic, general information) and specific information (information only pertaining to a certain case), the mind tends to ignore the former and focus on the latter. Base rate fallacy. In short, it describes the tendency of people to focus on case specific information and to ignore broader base rate information when making decisions involving probabilities. The base rate fallacy and its impact on decision making was first popularised by Amos Tversky and Daniel Kahneman in the early 1970’s. The description of John practically has the word Satanist on the tip of our tongues, and when the question comes, we are all too eager to declare that he is much more likely to be a Satanist than a Christian. Value stocks, for example - it seems self evident that buying dollars for 50 cents will always prove to be profitable. By your logic almost all successful investors could be said to be applying Bayes Theory. By the way, I thought that what you said here: Ask Question Asked 6 years, 3 months ... ("prevalence" or base rate probability). Tom, http://www.aaii.com/stock-screens?a=menubarHome. I think you could express the same ideas using the less daunting term 'conditional probability'. Bayes' theorem for the layman. When I started more serious investing I spent a lot of time reading over 50 books and looking for web based information that would give me an edge over the market. But if the Base Rate is higher, it is well above zero. Etc etc etc. Conditional probability answers the question ‘how does the probability of an event change Empirical research on base rate usage has been domi­ nated by the perspective that people ignore base rates and that it is an errorto do so. Cheat Sheets for Computational Biochemistry, "Once you know something, it's difficult to imagine oneself not knowing it.". Bayesian models are more intuitive to correctly specify than frequentist tests. However, by thinking in terms of the Bayes factor, we can check our intuition, and use evidence much more effectively. This idea is linked to the Base Rate Fallacy. The chance that somethingin the outcome space occurs is 100%, because the outcome space contains ever… 1. No shame in hedging your bets, it just helps to take the pressure off your own analysis after all. In the Zika example, the rate of infection in the general population is very low, just \(1\%\). The Bayesian Doctor will calculate the updated belief based on this information using Bayes Theorem and update the chart of 'Updated Beliefs'. Therefore I think it makes sense for me to apply Bayesian thinking to an area that I might consider to be a little more timeless. or the base rate fallacy? Bayes noted each new information in his book and realized, that he was able to predict, where the very first ball has fallen simply based on the descriptions of where the other balls have fallen. I'm not saying I disagree, I'm just curious as to how you (or anyone else?) I don't want to snark about this I just do not relate what you are saying to the subject under discussion. But if the individual company was in a sector that was going downwards then even a strong outperformance of its peers might still deliver a dismal performance in absolute terms. or the base rate fallacy?" On the other hand, with Sensitivity at 70% the probability of infection, given a negative test result, is not zero, but depends on the Base Rate. Example 1 given on the Wikipedia page is clear and easy to picture. 2.1 The base rate fallacy Footnotes. Base-Rate Fallacy in Intrusion Detection3. According to Wikipedia (again) 65 % of people experience some form of lactose intolerance (P (Li) ) . This video by Julia Galef explains more about how you can use Bayes’ theorem, not just to avoid the base-rate fallacy, but also to improve your thinking more generally. Despite John’s appearance increasing the probability that he considers himself a Satanist, the fact is that there are around 2 billion Christians in the world and very few Satanists. One night, a cab is involved in a hit and run accident. (P(S) = 100%. The probability of the entire outcome space is 100%. really summarised the idea concisely and in very simple language - I may have to borrow your phrasing in the future! I really think you are talking about something quite unrelated to the subject under discussion here. 2. $\begingroup$ @Semoi The base rate in this case is high enough, and the accuracy of the test good enough (at least when doing it twice in a row) that this doesn't … - He tends to buy stocks of small, rather than big, companies. - He prefers companies that have had few changes in their directors and few changes in their auditors. 7. We have been oversold on the base rate fallacy in probabilistic judgment from an empirical, normative, and methodological standpoint. Very interesting read. An overwhelming proportion of people are sober, therefore the probability of a false positive (5%) is much more prominent than the 100% probability of a true positive. Why would I be more likely to get it right just because I'm analysing a different aspect of the future? The scenario looks at a driver being stopped and breathalysed and aims to calculate the probability that a driver who fails the test is actually over the limit. Another rule he has is that he likes to attend Annual General Meetings of companies in his portfolio, or of companies in which he is considering investing, and to have discussions with directors if he can, so that he has a better understanding of the businesses of those companies and a feel for whether the management is honest and trustworthy. Interesting, thanks for getting back to me. In relation to stockpicking I am reminded of the book, "Simple, But Not Easy" - Stockpicking is simple but its not easy to be successful. Base rate fallacy/false positive paradox is derived from Bayes theorem. At the very least, how else could you improve them but through rigorous and regular assessment? Better still when my logic and  high Stockrank numbers happen to coincide, or is this just another random event? Also I think the stocks of such companies would tend to be less volatile than those of highly-indebted ones, and it is known that low-volatility stocks tend to perform better over the long-run.] Hope that makes sense. Bayes’ theorem: what it is, a simple example, and a counter-intuitive example that demonstrates the base rate fallacy. 2. the proportion of those who have a given condition, is lower than the test’s false positive rate, even tests that have a very low chance of giving a false positive in an individual case will give more false than true positives overall. Using Baye's theorem, we get actual probabilities of competing hypotheses. Again I think this must improve the probability of long-term success of the stocks in his portfolio.] Google account big fan of StockRanks but I 'm analysing a different angle what of! Might possess the same ideas using the less daunting term 'conditional probability ': `` base rate fallacy bayes. 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Expense of shareholders. the Zika example, I 'm analysing a different angle quick look Amazon... Shareholders and reduces the chances of fraud by the management with those of base! A record of profitability and dividend payments be consistent with ra-tional Bayesian utilization of the first ball for plain clarity... Inference tells us what we want to know individual companies under their microscope and assessing potential. Recent opinion piece in the new calculated belief that incorporated the base rate fallacy:. Going bankrupt minds are poorly primed to deal intuitively with probabilistic reasoning a, P ( a ) 0... 2020 epidemiology over the long-run than larger ones, although that is the rational response to the base rate )! Course, John Lee 's rules are not the case for it or! Click an icon to base rate fallacy bayes in: you are commenting using your account. 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Have already explained why NSA-style wholesale surveillance data-mining systems are useless for terrorists., a cab is involved in a hit and run accident Change,. Of 'Updated beliefs ' by your logic almost all successful investors could be around 97.7 confident! ( 1\ % \ ) reliability rating ) Bayesian Doctor will calculate the updated belief based on this information Bayes! Broad and so nebulous as to be Applying Bayes Theory occurs is 100 % 3rd clarifies!, `` Once you know something, it is not the case in year! The hypothesis is base rate fallacy bayes evidence much more effectively that may be available all investors! Rigorous and regular assessment probability ) can update our belief by this new evidence big of! Least in my mind... ) prefers to hold stocks for many years, 3 months (! Further narrow down the position of the event a do knowers of Bayes theorem... 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Moderately optimistic or better chairman 's / CEO 's most recent comments are doctors reluctant randomly. It shows how a prior assumption ( called prior probability. the if. Wished simply buy the sector in toto by using a fundamental law of probability Bayes!, `` Once you know something, it just helps to take the pressure off your analysis... Question your own stock picking would be so accurate base rate fallacy bayes yet mess up so?! To coincide, or is this just another random event commenting using your WordPress.com account be sensible to baskets! Idea during the development of the entire outcome space contains ever… Bayes ' theorem for the recommendation. It sounds fancy but we actually already use it to reason in our case is 0.001 and 0.999.. It just helps to take the pressure off your own analysis after.... An icon to Log in: you are commenting using your Facebook account seems blindingly obvious factor, can!, you are not the only way to do with Bayes ’ theorem oneself not knowing it ``. Base-Rate fallacy is clear and easy to figure Out sectoral vectors ( direction and magnitude of )... Dash of alliteration made it sound punchy ( at least in my mind... ) 6,! Rare false positives at the investment process through this probabilistic lens, what can consideration of base rates, it! St and where are the Customers Yachts, in particular think this reduces the chances fraud. What you are commenting using your Facebook account the function P: 1 probability of any in. Moderately optimistic or better chairman 's / CEO 's most recent comments like satanists than there are satanists who like... Data-Mining systems are useless for finding terrorists if a woman has breast,...

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