base-rate-fallacy

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.

Connected Business Concepts

Heuristics

heuristic
As highlighted by German psychologist Gerd Gigerenzer in the paper “Heuristic Decision Making,” the term heuristic is of Greek origin, meaning “serving to find out or discover.” More precisely, a heuristic is a fast and accurate way to make decisions in the real world, which is driven by uncertainty.

Bounded Rationality

bounded-rationality
Bounded rationality is a concept attributed to Herbert Simon, an economist and political scientist interested in decision-making and how we make decisions in the real world. In fact, he believed that rather than optimizing (which was the mainstream view in the past decades) humans follow what he called satisficing.

Second-Order Thinking

second-order-thinking
Second-order thinking is a means of assessing the implications of our decisions by considering future consequences. Second-order thinking is a mental model that considers all future possibilities. It encourages individuals to think outside of the box so that they can prepare for every and eventuality. It also discourages the tendency for individuals to default to the most obvious choice.

Lateral Thinking

lateral-thinking
Lateral thinking is a business strategy that involves approaching a problem from a different direction. The strategy attempts to remove traditionally formulaic and routine approaches to problem-solving by advocating creative thinking, therefore finding unconventional ways to solve a known problem. This sort of non-linear approach to problem-solving, can at times, create a big impact.

Moonshot Thinking

moonshot-thinking
Moonshot thinking is an approach to innovation, and it can be applied to business or any other discipline where you target at least 10X goals. That shifts the mindset, and it empowers a team of people to look for unconventional solutions, thus starting from first principles, by leveraging on fast-paced experimentation.

Biases

biases
The concept of cognitive biases was introduced and popularized by the work of Amos Tversky and Daniel Kahneman in 1972. Biases are seen as systematic errors and flaws that make humans deviate from the standards of rationality, thus making us inept at making good decisions under uncertainty.

Dunning-Kruger Effect

dunning-kruger-effect
The Dunning-Kruger effect describes a cognitive bias where people with low ability in a task overestimate their ability to perform that task well. Consumers or businesses that do not possess the requisite knowledge make bad decisions. What’s more, knowledge gaps prevent the person or business from seeing their mistakes.

Occam’s Razor

occams-razor
Occam’s Razor states that one should not increase (beyond reason) the number of entities required to explain anything. All things being equal, the simplest solution is often the best one. The principle is attributed to 14th-century English theologian William of Ockham.

Mandela Effect

mandela-effect
The Mandela effect is a phenomenon where a large group of people remembers an event differently from how it occurred. The Mandela effect was first described in relation to Fiona Broome, who believed that former South African President Nelson Mandela died in prison during the 1980s. While Mandela was released from prison in 1990 and died 23 years later, Broome remembered news coverage of his death in prison and even a speech from his widow. Of course, neither event occurred in reality. But Broome was later to discover that she was not the only one with the same recollection of events.

Crowding-Out Effect

crowding-out-effect
The crowding-out effect occurs when public sector spending reduces spending in the private sector.

Bandwagon Effect

bandwagon-effect
The bandwagon effect tells us that the more a belief or idea has been adopted by more people within a group, the more the individual adoption of that idea might increase within the same group. This is the psychological effect that leads to herd mentality. What is marketing can be associated with social proof.

Read Next: BiasesBounded RationalityMandela EffectDunning-Kruger

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