What Is Base Rate Fallacy And Why It Matters In Business

The base rate fallacy occurs when an individual inaccurately judges the likelihood of a situation occurring by not considering all relevant data.

Understanding the base rate fallacy

The base rate fallacy is based on a statistical concept called the base rate. In simple terms, it refers to the percentage of a population that has a specific characteristic.

For example:

  • The base rate of office buildings in New York City with at least 27 floors is 1 in 20 (5%).
  • The base rate of global citizens owning a smartphone is 7 in 10 (70%).
  • The base rate of left-handed individuals in a population is 1 in 10 (10%).

Regardless of the statistic, the base rate fallacy describes the tendency for an individual to discount existing (base rate) information in favor of new information. In discounting base rate information, the individual is contravening the fundamental rules of evidence based logical reasoning.

These fallacies are common in the finance industry, where investors buy or sell shares based on irrelevant and irrational information. This causes many investors to overreact to fluctuating market conditions, despite the availability of base rate statistics. 

For example, a listed company may display consistent, historical growth that has contributed to significant base rate data. Here, the data may show that the company’s share price appreciates at the rate of 35% per year.

If investors ignore this information and decide to sell on a very occasional red day, they are operating under the base rate fallacy. In other words, they have not considered the fundamental aspects of the company or the fact that share price appreciation is very rarely linear.

Avoiding the base rate fallacy

To avoid the base rate fallacy, individuals and businesses should:

  • Pay more attention to base rate information. This includes research and due diligence.
  • Understand that past performance or behavior is not a valid predictor of future performance or behavior.
  • Consider individual segments of their target audience during product development. While a business might get excited about adding a new feature to its product range, it must first consider what percentage of their customers would find value in it.
  • Always segment using A/B testing to ensure that they are optimizing for base rate information. This increases qualified leads in the target audience, resulting in higher conversion rates.
  • Refrain from making statistical inferences in marketing campaigns. Many consumers have difficulty interpreting data and others simply don’t have the time or patience. In any case, such inferences can be misleading because they fail to address the baseline data for individual consumers. Instead of making unsubstantiated claims, it’s more effective to detail how a product or service solves a problem the consumer is experiencing.
  • Make a commitment to not revert to effortless, automatic ways of thinking. Before each decision is made, the probability of a given event occurring should be rigorously assessed.

Key takeaways:

  • The base rate fallacy describes a tendency to erroneously predict the likelihood of an event without considering all relevant data.
  • Base rate fallacies are common in the finance industry when investors fail to incorporate historical data into the future movement of share prices.
  • The base rate fallacy can occur in any situation where inferences are made about data. Therefore, businesses need to be vigilant in their operations, product development, and marketing communications.

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Published by

Gennaro Cuofano

Gennaro is the creator of FourWeekMBA which target is to reach over two million business students, executives, and aspiring entrepreneurs in 2020 alone | He is also Head of Business Development for a high-tech startup, which he helped grow at double-digit rate | Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy | Visit The FourWeekMBA BizSchool | Or Get in touch with Gennaro here