The Investment Scientist

Representative Heuristic, Base Rate Neglect and Freaked Out Investors

Posted on: March 31, 2020

 

28_base-rate-neglect.jpgAllow me to ask you a seemingly unrelated question: what do you think the most common hair color in Ireland is? If you answered red, you are like the majority of people, but you are also wrong. The most common hair color in Ireland is dark brown (80%.) 

As you answered that question, what went through your mind? What mechanism caused you to arrive at the wrong answer? How is it relevant to stock market investing? I will answer these questions one by one in the space below.

If you answered red, you were using a mental shortcut called the representative heuristic to answer the question. What is the representative heuristic, exactly? It essentially says we humans tend to erroneously equate what is representative to what is likely. Indeed, red hair is representative of Irish people. Just under 10% of the Irish are redheads, compared to 1% of the rest of Europe. So the typical Irish in your head is a redhead, probably wearing green clothes and holding a pint of Guinness. Since you can easily recall a redhead Irish in your mind, you think therefore that the Irish are more likely to be redheads.

If only you had known the base rate of hair colors in Ireland: 80% dark brown, 10+% blonde and 10-% red, you would have gotten the right answer. But this base rate knowledge is so boring, who would hold that in their memory? Let’s just admit it, most of us suffer from base rate neglect, whether it’s Irish hair color or stock market crashes.

In the latter part of last year, I had discussions with many of my larger clients about rolling back their risk exposure. For example, if a client had a target allocation of 60/40, we would reduce the target to 50/50, with an understanding that if the market should give us a discount of more than 20%, we would revert the target back to 60/40.

Did I have clairvoyance about the pending coronavirus market crash? Of course not. I am not God, and I am not Senator Burr, who gets top secret intelligence briefings. My advantage, then and now, is that I am not suffering from base rate neglect. I know that historically, a 30+% market discount occurs once every 10 years or so, and that the last one was in 2008. By the end of last year, it had been eleven years. It was the right time to take precautions. So when it actually happened, I wasn’t surprised and I wasn’t freaked out, unlike many investors.Thus I was able to write “Once A Decade Discount of Stock Prices.”

With the base rate knowledge, I also assess that a 50+% discount is theoretically possible but practically not probable because that level of discount only happens roughly once a century. The last time was also in 2008, and the base rate suggests it’s too soon.

It’s not just in investing, whether its’ coronavirus, plane crashes or shark attacks, base rate neglect in risk assessment is common. The base rate knowledge is often the most effective cure for irrational fear.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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