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. Base rate fallacy example. That all makes sense and in particular your 3rd paragraph clarifies nicely. I am not saying that it is easy to figure out sectoral vectors (direction and magnitude of movement). 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. 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! This example, I’ve visualized from a video by Veritassium called “The Bayesian Trap”. The probability of the entire outcome space is 100%. If so, why? 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. View all posts by kilian. Namely, if the Base rate is low, say 0.1%, the probability is practically zero. The rate at which something happens in general is called the base rate. 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. We can avoid this fallacy using a fundamental law of probability, Bayes’ theorem. 1. Obviously you would want to invest in companies in that sector. People tend to simply ignore the base rates, hence it is called (base rate neglect). 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. In this case, throwing a coin will more accurately tell, if you have the disease. By looking in the table we can simply extract the data: posterior = (prior * probability of prior given new evidence) / all evidence. Namely, if the Base rate is low, say 0.1%, the probability is practically zero. In that case, each new ball (new information) updated his belief. Be able to organize the computation of conditional probabilities using trees and tables. He says this is a way of limiting the size of his loss if he has made a bad selection of a particular stock, thereby preserving capital for better use elsewhere. Base rate fallacy/false positive paradox is derived from Bayes theorem. When the incidence, i.e. Again I think this must improve the probability of long-term success of the stocks in his portfolio.] There is no such thing as a negative probability.) These are most easily described and understood with an example, which I have shamelessly sourced from Wikipedia. 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. 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. or the base rate fallacy?" 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. This is where we find out that our minds are poorly primed to deal intuitively with probabilistic reasoning. Bayes’ theorem: what it is, a simple example, and a counter-intuitive example that demonstrates the base rate fallacy. Fill in your details below or click an icon to log in: You are commenting using your WordPress.com account. It is remarkable just how many of these US "Guru" screen selections have beaten the US market, without direct human intervention. - He prefers 'family-run' companies in which the directors have large shareholdings themselves, have 'clean' reputations and have an attitude of being 'stewards' of their shareholders money. The base-rate fallacy only occurs with frequentist methods because they cannot use prior information in a straightforward way. Why do knowers of Bayes's Theorem still commit the Base Rate Fallacy? All the best, 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? https://www.gigacalculator.com/calculators/bayes-theorem-calculator.php The English statistician Thomas Bayes has done an interesting experiment on how to visualize that. 1 For a more extensive treatment see one of John Kruschke’s blog posts. medical tests, drug tests, etc. When the incidence, i.e. But, the big but in general, hospitals double check some positive results and you therefore could trust your hospitals. If house building is the place to be then it's more important to capture the sectoral gains than it is to agonise about which individual stock is best. The structure of this problem is the same as that of the base rate fallacy. 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 . Why do knowers of Bayes's Theorem still commit the Base Rate Fallacy? Impact on Intrusion Detection Systems4. 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 write that the probability of the event is . 47.37% (90 / (90 + 100)). Base-Rate Fallacy in Intrusion Detection3. 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. [It is well known that 'value' stocks and stocks with high dividend yields tend as a group to out-perform over the long-run.] [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.] 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. 2 Review of Bayes’ theorem Recall that Bayes’ theorem allows us to ‘invert’ conditional probabilities. 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. Of course, John Lee's rules are not the only way to do that. 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. Understand the base rate fallacy thoroughly. Better still when my logic and high Stockrank numbers happen to coincide, or is this just another random event? Base Rate Fallacy。 The Base Rate in our case is 0.001 and 0.999 probabilities. Base rate fallacy. Consequently there are more Christians who look like satanists than there are satanists who look like satanists. 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. 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! In the Zika example, the rate of infection in the general population is very low, just \(1\%\). This means that the odds are still overwhelmingly in favour of John being a Christian. Bayes’ theorem states that: The above looks complicated, so let’s go back a bit. 8.5 The Base Rate Fallacy. One great example of the Bayes theorem and how it impacts our daily decision making is the base rate fallacy. 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 we rst learned Bayes’ theorem we worked an example about screening tests showing that P(DjH) can be very di erent from P(HjD). Base Rate Fallacy: This occurs when you estimate P(a|b) to be higher than it really is, because you didn’t take into account the low value (Base Rate) of P(a). 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. So stockpicking for me its understanding that I have all the human bias's and need all the help I can get! 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. In relation to stockpicking I am reminded of the book, "Simple, But Not Easy" - Stockpicking is simple but its not easy to be successful. 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. 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. 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. 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. Christians might possess the same characteristics only rarely but their numbers are big. Bayesian models are more intuitive to correctly specify than frequentist tests. 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. 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. Spare production capacity was at an all time low. General explanation from Wikipedia:. 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. I also recommend: Reminisences of a Stockmarket Trader, One up on Wall St and Where are the Customers Yachts, in particular.
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