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. Bayes Theorem is a mathematical equation where you can input the Base Rate for an event along with the probabilities associated with new information to get the actual overall probability for the event. I think that is the rational response to the Bayesian insights. 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. medical tests, drug tests, etc. The rate at which something happens in general is called the base rate. 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. 7. All the best, But, the big but in general, hospitals double check some positive results and you therefore could trust your hospitals. But if the Base Rate is higher, it is well above zero. At the empirical level, a thorough examination of the base rate literature (including the famous lawyer–engineer problem) does not support the conventional wisdom that people routinely ignore base rates. I'd look at things from a different angle. Value stocks, for example - it seems self evident that buying dollars for 50 cents will always prove to be profitable. Bayes’2. We are told that if a person is actually drunk, the test will indicate so 100% of the time but, in addition to this, 5% of people tested will display a false positive – the test says they are drunk when they…. Change ), How to do Science: Bayes Theorem and the base rate fallacy, Distinction between Frequentist and Bayesian Approaches, being identified positive, given that you’re sick, being identified positive, given that you not carry the disease, being identified negative, while not carrying the disease, being identified negative, but actually having the disease. They know about it. In fact at the moment I have a stockpicked quality/momentum type portfolio and a more recently a rules based high Stockrank portfolio to see what happens. Economic development was bringing many new consumers into the marketplace. The chance that somethingin the outcome space occurs is 100%, because the outcome space contains ever… Base rate fallacy/false positive paradox is derived from Bayes theorem. 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. Base rate fallacy example. This idea is linked to the Base Rate Fallacy. Why do knowers of Bayes's Theorem still commit the Base Rate Fallacy? - He uses a 20% stop-loss rule to sell any poorly-performing stocks, but he ignores stop-losses if there is a major overall market fall. - He tries to buy stocks that are on modest valuations, which he defines as stocks that have an attractive yield and a low price earnings ratio and /or a discount to net asset value / real worth. 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. Again I think this must improve the probability of long-term success of the stocks in his portfolio.] [This must greatly reduce the probability of any companies in his portfolio going bankrupt. "If you will allow me to play Devil's advocate for a minute though, how would you say that picking sectors is different from picking stocks? Example 1: Even if you are brilliant, you are not guaranteed to be admitted to Harvard: P(Admission|Brilliance) is low, because P(Admission) is low. When the incidence of a disease in a population is low, unless the test … Bayesian inference includes conditional probability. 2 Conditional Probability. Lets see how that looks like, by comparing a rare disease (Multiple sclerosis) with a more common disease (lactose intolerance, technically not a disease). 1 For a more extensive treatment see one of John Kruschke’s blog posts. The probability of every event is at least zero. If you are not comfortable with Bayes’ theorem you should read the example in the appendix now. If so, why? In other words, he greatly improved his 'base rate' probabilities of investing success by following those rules. 1. 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. 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! Does make me think that I am not quite so good a stock picker after all and that  Stockrank factors which remove my stock picker logic should be given more prominence. This example, I’ve visualized from a video by Veritassium called “The Bayesian Trap”. So the learning I take from that is to spend more time choosing sectors than identifying individual stocks. is has the same 99.9% true positive rate and the probability of being tested negative, while still developing MS is also pretty low (false positive: 0.02 %). … 2. Let’s suppose that there is a test for telling you if you will develop lactose intolerance in your life. The English statistician Thomas Bayes has done an interesting experiment on how to visualize that. We have been oversold on the base rate fallacy in probabilistic judgment from an empirical, normative, and methodological standpoint. Jun 8, 2020 epidemiology. Bayes’ theorem has been a controversial idea during the development of statistical reasoning, with many authorities dismissing it as an absurdity. Yes great article. By your logic almost all successful investors could be said to be applying Bayes Theory. Applications and examples. Geeky Definition of Base Rate Fallacy: The Base Rate Fallacy is an error in reasoning which occurs when someone reaches a conclusion that fails to account for an earlier premise – usually a base rate, a probability or some other statistic. Bayes’Theorem and Base-Rate FallacyTheorem and Base-Rate Fallacy 3. Cheat Sheets for Computational Biochemistry, "Once you know something, it's difficult to imagine oneself not knowing it.". 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). As far as I'm concerned, whatever works, works. 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! 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. [Again I think this must improve the probability of out-performance by those stocks of the market as a whole.] Of course, John Lee's rules are not the only way to do that. 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. We can see that the probability of the woman has cancer is calculated as 7.76%. 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). Bayes' theorem for the layman. Why would I be more likely to get it right just because I'm analysing a different aspect of the future? Be able to organize the computation of conditional probabilities using trees and tables. This is however much, much lower than lactose intolerance, with 0.09%. A witness claims the cab was green, however later tests show that they only correctly … One night, a cab is involved in a hit and run accident. Base-Rate Fallacy in Intrusion Detection3. [I think another way to look at this rule is he is using negative momentum to make some selling decisions, and it is well known that stocks with recent negative momentum tend to under-perform the market as a whole over the short-term.] 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). 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. Better still when my logic and  high Stockrank numbers happen to coincide, or is this just another random event? Easy Definition of Base Rate Fallacy: Don't think "99% accurate" means a 1% failure rate.There's far more to think about before you can work out the failure rate. P(E|H) is the probability of the evidence if the hypothesis is true. At the very least, how else could you improve them but through rigorous and regular assessment? I don't want to snark about this I just do not relate what you are saying to the subject under discussion. This is the base rate fallacy in a nutshell. [I think this reduces the probability of him selecting a stock that will perform badly in the short-term.] So even if he had selected his stocks at random from the pool that remained after removing those stocks that did not satisfy his rules, I suspect he would still have done very well over the years (although perhaps not as well as he actually has done after using his skill and judgement in selecting individual stocks from that pool). I very recently started Kahneman's book myself (after it sitting in the ever growing 'to read' pile for months) and as you say he covers Bayes' Theorem well. One great example of the Bayes theorem and how it impacts our daily decision making is the base rate fallacy. We have been oversold on the base rate fallacy in probabilistic judgment from an empirical, normative, and methodological standpoint. This means that the odds are still overwhelmingly in favour of John being a Christian. Which might also strengthen the case for IT's or OEICs or ETF's which provide broad coverage of target sectors. General explanation from Wikipedia: When the incidence, i.e. 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. Footnotes. In fact, with every ball and new information, Bayes was able to further narrow down the position of the first ball. Base Rate Fallacy。 The Base Rate in our case is 0.001 and 0.999 probabilities. I have already explained why NSA-style wholesale surveillance data-mining systems are useless for finding terrorists. 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. The Bayesian Doctor will calculate the updated belief based on this information using Bayes Theorem and update the chart of 'Updated Beliefs'. 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. So stockpicking for me its understanding that I have all the human bias's and need all the help I can get! 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. This video by Julia Galef explains more about how you can use Bayes’ theorem, not just to avoid the base-rate fallacy, but also to improve your thinking more generally. An overwhelming proportion of people are sober, therefore the probability of a false positive (5%) is much more prominent than the 100% probability of a true positive. But if the Base Rate is higher, it is well above zero. - He looks for moderately optimistic or better chairman's / CEO's most recent comments. Koehler: Base rate fallacy superiority of the nonnative rule reduces to an untested empirical claim. Where do you stop with this line of thinking though? 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. I am not saying that it is easy to figure out sectoral vectors (direction and magnitude of movement). 6. Good luck with your investing, Tom. Terrorists, Data Mining, and the Base Rate Fallacy. Using Baye's theorem, we get actual probabilities of competing hypotheses. Thanks - my apologies for the confusion! 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. However, to do that, we need to include the possibility that we could be one of the rare false positives. Ian, I've just finished reading the book 'How to make a million - slowly' by Lord John Lee, who has been an extremely successful private investor over many years. Base rate fallacy/false positive paradox is derived from Bayes theorem. Answer to the Thought Experiment: The exact answer to this problem depends upon what percentage of the population is homosexual. Namely, if the Base rate is low, say 0.1%, the probability is practically zero. 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. In fact, each new experiment and new observation (given that the experimental parameters allow a deduction of a new direction) updates our beliefs, i.e. Amazon through www.audible.co.uk have a good selection of investment audiobooks for instant download to a smartphone - Great for listening to in the car on a long journey. I also recommend: Reminisences of a Stockmarket Trader,  One up on Wall St and Where are the Customers Yachts, in particular. There is no such thing as a negative probability.) 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. I really think you are talking about something quite unrelated to the subject under discussion here. My own experience is that it has several times been possible to call the oil sector and to position oneself with advantage. I'm currently intending to pursue the use of investment trusts to allow me to step back from stock selection and spend more time on sector selection. After having received the test result (new evidence), we can update our belief by this new evidence. I chose the title because the dash of alliteration made it sound punchy (at least in my mind...). 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 . I was using Lord John Lee as an example of someone who been extremely successful at investing over many years, and whose success supports what Tom Firth wrote in that section. Be able to use Bayes’ formula to ‘invert’ conditional probabilities. Here’s a more formal explanation:. (P(S) = 100%. If a woman has breast cancer, the probability that she tests positive is 90% ("sensitivity" or reliability rating). That all makes sense and in particular your 3rd paragraph clarifies nicely. 8.5 The Base Rate Fallacy. ( Log Out /  Conclusion5. Let’s say we have two events and . 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. Ian, P.S. Student of Life About this I just do not relate what you are not the only way to with! 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