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The base rate fallacy and its impact on decision making was first popularised by Amos Tversky and Daniel Kahneman in the early 1970’s. Bayes’ theorem states that: The above looks complicated, so let’s go back a bit. 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. Although John Lee obviously has great skill as a stock-picker, I think it is very interesting [in the light of this excellent article by Tom Firth on Bayes Theorem and conditional probability] how John Lee has increased the odds of long-term success by the rules he uses to reduce the size of the pool of stocks that he picks from. 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. Quite a few of his examples relate to gambling, but they could equally as well be attributed to our "investment" decisions. Birn-baum showed that behavior described as "ne-glect of base rate" may be consistent with ra-tional Bayesian utilization of the base rate. 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. Thus, it is not at all clear that Bayes' theorem deserves the … Interesting, thanks for getting back to me. This idea is linked to the Base Rate Fallacy. Unfortunately, the human brain does not always deal with evidence properly. But if the Base Rate is higher, it is well above zero. A really excellent and thought provoking piece, thank you. 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. I think you could express the same ideas using the less daunting term 'conditional probability'. This updated belief (the resulting posterior probability) incorporates all the evidence of that claim. Tom. This basically means. But, the big but in general, hospitals double check some positive results and you therefore could trust your hospitals. Seems to me that your thought process leads to the idea of emulating investment heroes - "What would Warren Buffett do?" Consequently there are more Christians who look like satanists than there are satanists who look like satanists. 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. By the way, I thought that what you said here: Where do you stop with this line of thinking though? 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. 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. I'm not saying I disagree, I'm just curious as to how you (or anyone else?) It shows how a prior assumption (called prior probability) is updated in a light of new evidence. Conclusion5. This and other experiments led eventually to a mathematical formulation of Bayes theorem. 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. In the taxicab example, the base rate for blue cabs was \(15\%\). The base rate fallacy reconsidered: Descriptive, normative, and methodological challenges. Thomas Bayes and was first published in 1763, 2 years after his death. Let’s suppose that there is a test for telling you if you will develop lactose intolerance in your life. Behavioral and brain sciences, 19(1), 1-17. Again I think this must improve the probability of long-term success of the stocks in his portfolio.] 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 … Base-Rate Fallacy in Intrusion Detection3. I think that is the rational response to the Bayesian insights. Have a good evening, Be able to organize the computation of conditional probabilities using trees and tables. By your logic almost all successful investors could be said to be applying Bayes Theory. Let A and B be events. Which might also strengthen the case for IT's or OEICs or ETF's which provide broad coverage of target sectors. It sounds fancy but we actually already use it to reason in our everyday lives. [This must greatly reduce the probability of any companies in his portfolio going bankrupt. P(E|H) is the probability of the evidence if the hypothesis is true. Base Rate Fallacy。 The Base Rate in our case is 0.001 and 0.999 probabilities. 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. The 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. Bayes’ theorem was developed by Rev. Why are spam filters claimed to be so accurate and yet mess up so often? 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! Better still when my logic and high Stockrank numbers happen to coincide, or is this just another random event? Christians might possess the same characteristics only rarely but their numbers are big. - He prefers to hold stocks for many years, rather than regularly 'churning' his portfolio, and he lets profitable holdings run. General explanation from Wikipedia: When the incidence, i.e. ( Log Out / [Small companies tend to perform better over the long-run than larger ones, although that is not the case in every year.] At the very least, how else could you improve them but through rigorous and regular assessment? 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). 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). So the learning I take from that is to spend more time choosing sectors than identifying individual stocks. I think that greatly improved the conditional probabilities (which could in principle be calculated using Bayes Theorem if one had all the data) of successful outcomes from his portfolios over the long-term. A classic explanation for the base rate fallacy involves a scenario in which 85% of cabs in a city are blue and the rest are green. Generally, when you see evidence, it can partly confirm your hypothesis, but at the same time also partly confirm another (competing) hypothesis. 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! We have been oversold on the base rate fallacy in probabilistic judgment from an empirical, normative, and methodological standpoint. Jun 8, 2020 epidemiology. 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! 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”. As we shall see, assessments that underestimate the importance of a statistical base rate commit the fallacy known as ‘base rate neglect’. Much of the time it is really difficult to get a read on most of the market. 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. If Hand Dare events, then: P(P(HjD) = DjH)P(H) P(D) Our view is that Bayes’ theorem forms the foundation for inferential statistics. There is no such thing as a negative probability.) This means that the odds are still overwhelmingly in favour of John being a Christian. We can see that the probability of the woman has cancer is calculated as 7.76%. 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. If a woman has breast cancer, the probability that she tests positive is 90% ("sensitivity" or reliability rating). If so, why? Hi Ian, If a woman has breast cancer, the probability that she tests positive is 90% ("sensitivity" or reliability rating). However, by thinking in terms of the Bayes factor, we can check our intuition, and use evidence much more effectively. So stockpicking for me its understanding that I have all the human bias's and need all the help I can get! Our prior belief of having the disease is just the distribution of the disease in the population, so 65% or 0.65 (P (Li)). 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. noted that research on the "base-rate fallacy" used an incomplete Bayesian analysis. 2. To date my second best sector based calls have been in fixed income pref shares, where I arrived late but still in time to join in. Base rate fallacy example. Worldwide around 90 per 100,000 people are exhibiting this auto-immune disease. He avoids start-ups and biotech or exploration stocks. [It is well known that 'value' stocks and stocks with high dividend yields tend as a group to out-perform over the long-run.] Understand the base rate fallacy thoroughly. In the taxicab example, the base rate for blue cabs was 15% 15 %. ( Log Out / 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. My own experience is that it has several times been possible to call the oil sector and to position oneself with advantage. Conclusion A person receiving a positive test could be around 97.7% confident that it correctly indicates the development of the lactose intolerance. View all posts by kilian. But if the Base Rate is higher, it is well above zero. 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. Spare production capacity was at an all time low. 1. Bayes’2. Here’s a more formal explanation:. In fact it might be sensible to buy baskets of stocks in the chosen sector rather than just one or two. Tournesol wrote: "yes but what on earth does any of that have to do with Bayes Theorem? People tend to simply ignore the base rates, hence it is called (base rate neglect). So we are restricting our view to where the evidences holds. The probability of every event is at least zero. 1 For a more extensive treatment see one of John Kruschke’s blog posts. I also recommend: Reminisences of a Stockmarket Trader, One up on Wall St and Where are the Customers Yachts, in particular. 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. - He tends to buy stocks of small, rather than big, companies. 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. 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. I have already explained why NSA-style wholesale surveillance data-mining systems are useless for finding terrorists.

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