Base Rate Fallacy

Categories: Metrics, Trading, Investing

This is the investment equivalent of saying your fave football team is terrible, and burning your jersey because they lost one game to an inferior opponent, even though they're now 9-1. You're basing too much of your judgment of your team's quality on a single, recent event (the loss) and ignoring the fact that they have a great quarterback, a stout defense, and a Hall of Fame coach.

Investors who look at one poor quarter of performance as a basis for not investing, thereby ignoring tons of long-standing info about the company's market position and overall strength, are guilty of falling for the base rate fallacy.

Related or Semi-related Video

Finance: What are normalized earnings?5 Views

00:00

Finance allah shmoop what are normalized earnings All right this

00:07

is norm or it's supposed to be We just couldn't

00:10

get the licensing rights from him So this is our

00:12

public domain version of norm from cheers Sorry And this's

00:17

normal that's a bell curve Yeah you're in the ebola

00:21

abatement business Each year the government spends a few bucks

00:25

on you Just keep you alive Is a business in

00:28

case Well you know a few hundred million peoples faces

00:31

start melting off like you know that scene in indiana

00:34

jones you know the good ones so your earnings are

00:38

usually here and here and here and here a buck

00:41

a buck twelve twenty three twenty four years I'm like

00:43

that But then one year after miss malaria's high school

00:46

biology class takes a field trip to study monkeys bats

00:50

and beetle crap in caves in central ghana Well your

00:54

business picks up So this year when the gove is

00:57

having to spend a fortune on ebola abatement you were

01:00

nine dollars and forty two cents a share And since

01:04

world awareness has suddenly shot up the most popular yahoo

01:07

search term index that thing well next year you'll still

01:11

learn five seventeen to share even though most the ebola

01:14

is pretty much gone now But then things quiet down

01:16

in life goes back to normal where your earnings are

01:21

you know normal and you could plot some kind of

01:23

line through them And if someone asked you what normalized

01:27

earnings are in your little ebola abatement company well you

01:30

could say that your normalized earnings are in about a

01:34

buck twenty Well fortunately making out with the nigerian fruit

01:37

bat is not normal so you probably don't have to 00:01:40.539 --> [endTime] worry about contracting ebola Ooh

Find other enlightening terms in Shmoop Finance Genius Bar(f)