Tom, Thanks for the feedback - I quite enjoyed writing this one. 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. Much of the time it is really difficult to get a read on most of the market. In other words, he greatly improved his 'base rate' probabilities of investing success by following those rules. 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. Not a single scientifically hold belief for something, let’s say that mitochondria are the “powerhouses” of the cell, is based on only one assumption or observation. This and other experiments led eventually to a mathematical formulation of Bayes theorem. Such a statement would be so broad and so nebulous as to be of no value. I concluded that what was needed was a historically successful set (or sets) of screening criteria and an investment approach that suits your personality so you stick with it. 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? The so-called Bayes Rule or Bayes Formula is useful when trying to interpret the results of diagnostic tests with known or estimated population-level prevalence, e.g. It shows how a prior assumption (called prior probability) is updated in a light of new evidence. That all makes sense and in particular your 3rd paragraph clarifies nicely. In fact at the moment I have a stockpicked quality/momentum type portfolio and a more recently a rules based high Stockrank portfolio to see what happens. Which might also strengthen the case for IT's or OEICs or ETF's which provide broad coverage of target sectors. Multiple sclerosis is one of the more common, rare diseases. 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. When the incidence of a disease in a population is low, unless the test … This basically means. Answer to the Thought Experiment: The exact answer to this problem depends upon what percentage of the population is homosexual. Namely, if the Base rate is low, say 0.1%, the probability is practically zero. I very recently started Kahneman's book myself (after it sitting in the ever growing 'to read' pile for months) and as you say he covers Bayes' Theorem well. $\begingroup$ @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 … Thomas Bayes and was first published in 1763, 2 years after his death. 1. Easy Definition of Base Rate Fallacy: Don't think "99% accurate" means a 1% failure rate.There's far more to think about before you can work out the failure rate. In my opinion just a few successful calls which are used as the basis for significant investments and which are held for significant periods can deliver life changing returns. Obviously you would want to invest in companies in that sector. 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. 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. Interesting, thanks for getting back to me. Christians might possess the same characteristics only rarely but their numbers are big. 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. Depletion was increasing. "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? Why would I be more likely to get it right just because I'm analysing a different aspect of the future? Therefore, in practice we almost always have to expand: Bayesian theorem basically tells us to look at all the cases where the evidence is true and then looking at the proportion of these evidences, where the hypothesis is also true. It is turning out to be the same market beating success story in the UK with many of the Stocko Guru and Stockrank screen selections to date. In this case, throwing a coin will more accurately tell, if you have the disease. When evaluating the probability of an event―for instance, diagnosing a disease, there are two types of information that may be available. Conditional probability answers the question ‘how does the probability of an event change 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.] Namely, if the Base rate is low, say 0.1%, the probability is practically zero. Intuitively, one might think that it is not much different from the example above. I really think you are talking about something quite unrelated to the subject under discussion here. noted that research on the "base-rate fallacy" used an incomplete Bayesian analysis. 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. Another early explanation of the base rate fallacy can be found in Maya Bar-Hillel’s 1980 paper, “The base-rate fallacy in probability judgments”. I'm not saying I disagree, I'm just curious as to how you (or anyone else?) The base rate fallacy and its impact on decision making was first popularised by Amos Tversky and Daniel Kahneman in the early 1970’s. really summarised the idea concisely and in very simple language - I may have to borrow your phrasing in the future! Base rate fallacy/false positive paradox is derived from Bayes theorem. [Again I think this must improve the probability of out-performance by those stocks of the market as a whole.] This is the new calculated belief that incorporated the base rate in the calculation. Why do knowers of Bayes's Theorem still commit the Base Rate Fallacy? This example, I’ve visualized from a video by Veritassium called “The Bayesian Trap”. Example 1 given on the Wikipedia page is clear and easy to picture. 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. In fact it is the opposite of drunken rationale and takes you though a history of the development of randomness theory and the need for the evolutionary human brain to look for cause and effect patterns that are either not there, or that we misinterpret. 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. Economic development was bringing many new consumers into the marketplace. 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. It is remarkable just how many of these US "Guru" screen selections have beaten the US market, without direct human intervention. When the incidence of a disease in a population is low, unless the test … Let A and B be events. support the ongoing hypothesis or refute the held beliefs. Change ), You are commenting using your Facebook account. There is no such thing as a negative probability.) The rate at which something happens in general is called the base rate. Koehler: Base rate fallacy superiority of the nonnative rule reduces to an untested empirical claim. 47.37% (90 / (90 + 100)). What the thread originator was getting at with Bayes was the need to separate the general/shared characteristics of a group or class of objects (their base rate) from the specific differences between individuals. (For every event A, P(A) ≥ 0. 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. People tend to simply ignore the base rates, hence it is called (base rate neglect). 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. [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.] 2.1 The base rate fallacy. Is it easier? When given relevant statistics about GPA distribution, students tended to ignore them if given descriptive information about the particular student even if the new descriptive information was obviously of little or no relevance to school performance. Base-Rate Fallacy in Intrusion Detection 4. Bayes’Theorem and Base-Rate FallacyTheorem and Base-Rate Fallacy 3. I found it a bit confusing when I first read it, because I had wrongly assumed from the title that it is about the Bank of England's base rate, but of course it is nothing to do with that! I have been listening to an excellent audiobook in the car (also available as a book) called, "The Drunkard's Walk: How Randomness Rules" by Prof L. Mlodinow . Conclusion5. P(E|H) is the probability of the evidence if the hypothesis is true. 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 … We can see that the probability of the woman has cancer is calculated as 7.76%. I have already explained why NSA-style wholesale surveillance data-mining systems are useless for finding terrorists. If you are not comfortable with Bayes’ theorem you should read the example in the appendix now. - He prefers companies that have had few changes in their directors and few changes in their auditors. This is the base rate fallacy in a nutshell. Base rate fallacy, also called base rate neglect or base rate bias, is a formal fallacy.If presented with related base rate information (i.e. I cannot find any of that reflected in your discussion of John Lee's approach that will help others to emulate it. A recent opinion piece in the New York Times introduced the idea of the “Base Rate Fallacy.”. That's not to say that I don't pick shares too because that is part of the fun of investing, but picking them from a pre-selection of shares that meet your criteria, does give an added confidence factor. Seems to me that your thought process leads to the idea of emulating investment heroes - "What would Warren Buffett do?" All the best, Why would I be more likely to get it right just because I'm analysing a different aspect of the future? I don't want to snark about this I just do not relate what you are saying to the subject under discussion. 2 Review of Bayes’ theorem Recall that Bayes’ theorem allows us to ‘invert’ conditional probabilities. If we test 100,000 people with this test, we get: As a person that receives a positive test result, how confident should you be in trusting that result? A really excellent and thought provoking piece, thank you. Impact on Intrusion Detection Systems 5. 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! 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…. 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). 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. Tom, Tom, Bayes (in green) was sitting was sitting with his back to plain table, with a book and pen. Suppose you came to the realisation that the oil sector was poised to outperform. medical tests, drug tests, etc. This is illustrated by the fact that he was one of the first investors in the UK to have an ISA portfolio worth a million pounds. Thus, it is not at all clear that Bayes' theorem deserves the … ". In the taxicab example, the base rate for blue cabs was \(15\%\). Here’s a more formal explanation:. You would be making a sector based decision. 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. [Small companies tend to perform better over the long-run than larger ones, although that is not the case in every year.] - He looks for established companies with a record of profitability and dividend payments. When we rst learned Bayes’ theorem we worked an example about screening tests showing that P(DjH) can be very di erent from P(HjD). These are most easily described and understood with an example, which I have shamelessly sourced from Wikipedia. General explanation from Wikipedia: When the incidence, i.e. 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! Base rate fallacy/false positive paradox is derived from Bayes theorem. [This greatly reduces his transaction costs, and transaction costs act like a tax on performance, so I think this is likely to improve his long-term results.] 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. - He tries to buy stocks that are on modest valuations, which he defines as stocks that have an attractive yield and a low price earnings ratio and /or a discount to net asset value / real worth. My own experience is that it has several times been possible to call the oil sector and to position oneself with advantage. The base rate fallacy is also known as base rate neglect or base rate bias. This means that the odds are still overwhelmingly in favour of John being a Christian. Geeky Definition of Base Rate Fallacy: The Base Rate Fallacy is an error in reasoning which occurs when someone reaches a conclusion that fails to account for an earlier premise – usually a base rate, a probability or some other statistic. The English statistician Thomas Bayes has done an interesting experiment on how to visualize that. We can avoid this fallacy using a fundamental law of probability, Bayes’ theorem. Better still when my logic and  high Stockrank numbers happen to coincide, or is this just another random event? Conclusion Jun 8, 2020 epidemiology. So the learning I take from that is to spend more time choosing sectors than identifying individual stocks. 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 am familiar with Bayes theorem and I am a big fan of StockRanks but I hadn't made the connection. In other words the base rate for share price growth in the oil sector would likely be stronger than the base rate for some other sector - say retail. Our intuition about what is, or is not evidence, and what is strong versus weak evidence, can be terribly wrong (see, for instance, the base rate fallacy). Be able to use Bayes’ formula to ‘invert’ conditional probabilities. Base Rate Fallacy。 The Base Rate in our case is 0.001 and 0.999 probabilities. 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. An example is scrutiny (and subsequent demolition) of Fortune 500 companies who hire or fire their CEO's for what turns out to be random short term financial success of failure. Interesting what you say about picking sectors, it makes sense in the Bayesian context and the house builders you mention are quite a good example. generic, general information) and specific information (information pertaining only to a certain case), the mind tends to ignore the former and focus on the latter.. Base rate neglect is a specific form of the more general extension neglect. If I was to employ such a strategy, my worry would be that I've essentially replaced one forecasting problem (the stock picking problem) with another almost identical forecasting problem (the sector picking problem). In fact, each new experiment and new observation (given that the experimental parameters allow a deduction of a new direction) updates our beliefs, i.e. might address those concerns. In fact it might be sensible to buy baskets of stocks in the chosen sector rather than just one or two. Bayes’ theorem states that: The above looks complicated, so let’s go back a bit. Bayes’ theorem has been a controversial idea during the development of statistical reasoning, with many authorities dismissing it as an absurdity. Consequently there are more Christians who look like satanists than there are satanists who look like satanists. is has the same 99.9% true positive rate and the probability of being tested negative, while still developing MS is also pretty low (false positive: 0.02 %). View all posts by kilian. ( Log Out /  The Bayesian Doctor will calculate the updated belief based on this information using Bayes Theorem and update the chart of 'Updated Beliefs'. You are told that “John is a man who wears gothic inspired clothing, has long black hair, and listens to death metal.”  You are then asked “How likely is it that he is a Christian, and how likely is it that he is a Satanist?”. The structure of this problem is the same as that of the base rate fallacy. Ask Question Asked 6 years, 3 months ... ("prevalence" or base rate probability). But, the big but in general, hospitals double check some positive results and you therefore could trust your hospitals. 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. But if the Base Rate is higher, it is well above zero. The rate at which something happens in general is called the base rate. Population growth was strong. 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. I do not claim any generalised success in other sectors but I'm working on it. Ian, P.S. A person receiving a positive test could be around 97.7% confident that it correctly indicates the development of the lactose intolerance. After having received the test result (new evidence), we can update our belief by this new evidence. Yes great article. Bayesian models are more intuitive to correctly specify than frequentist tests. Behavioral and brain sciences, 19(1), 1-17. There is an old rubric to the effect that it is more important to invest in the right sector than it is to invest in the right stock - and actually that is really a restatement of Bayesian thinking. Worldwide around 90 per 100,000 people are exhibiting this auto-immune disease. Consumption was growing strongly. PKA Change ), How to do Science: Bayes Theorem and the base rate fallacy, Distinction between Frequentist and Bayesian Approaches, being identified positive, given that you’re sick, being identified positive, given that you not carry the disease, being identified negative, while not carrying the disease, being identified negative, but actually having the disease. Generally, when you see evidence, it can partly confirm your hypothesis, but at the same time also partly confirm another (competing) hypothesis. Bayesian inference includes conditional probability. Ask Question Asked 6 years, 3 months ... ("prevalence" or base rate probability). The problem is the broader the asset the more efficient the market and the harder it is to do selection... or should we all trade currencies? 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.

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