Why base rate matters

A few years back, while deciding what colour car to buy, a friend of mine gave me a very strong opinion on the choice of colour. He said never to buy a white car! I was quite intrigued by the strong suggestion, and I asked him why. His sole reason for saying so was to keep me safe. He had observed over time and gathered through multiple observations and anecdotes that nearly 50 per cent of all accidents happen to white cars!

Whenever I am looking for shoes while shopping in the USA, I have extreme experiences. For the most part, I don’t get my shoe size when I like a pair of shoes, but there are also times when I get very lucky to find a 50 per cent price discount on my size in a clearance sale. Wonder why this happens to me!

Investors, mutual fund distributors and advisors alike have said that everyone talks about buying and when to buy, but when it comes to ‘when to sell’, the standard answer is “when you need the money or when you achieve your goals”. There are many people who don’t know what goal they are investing for; they are just investing to grow the money, but they also want to know when and how to sell. Even long-term investors with no goals around the corner sometimes need to sell because markets are very volatile and every crest is eventually followed by a trough.

The catch in all these observations, concerns or queries, stated or unstated, obvious or not, is the base rate. Nearly 50 per cent of all cars are white, and a large number of taxis that ply intercity long-distance routes are also white! Is it any surprise if they account for a similar proportion of accidents on the roads? The average shoe size in the USA for men is 10.5! Is it any surprise that 7.5 is either not easily available or out of stock, or what is available is an unsold old stock, which is why it is not widely made in the first place? Similarly, there is a long-term average rate of return that equity markets and different other asset classes have delivered. The average ranges also shift with changes in macro parameters, but if you do not have any goals and you don’t know when to sell, the least you can do is to sell when you have made way more than what past averages might indicate, and you buy when recent returns are way lower than what past average suggest in terms of expected returns!

It’s that simple, or not that simple, after all?

In the realm of decision-making and statistical reasoning, the concept of base rate fallacy occupies an important space. It is a cognitive error that occurs when individuals disregard or fail to account for the general frequency or probability of an event, while giving disproportionate weight to specific data or anecdotal evidence. The base rate fallacy arises when individuals focus on specific examples, observations or anecdotes related to a case without adequately considering the overall statistical context or base probability. For instance, many investors are highly enthused by the prospect of investing in startups; they might be swayed by a company’s innovative tech or a charismatic founder, overlooking the statistical reality that most startups fail within the first five years. Base rate information provides a foundational understanding of how often certain outcomes occur across a general population. For accurate decision-making, it is critical to integrate this data alongside specific details. Ignoring base rates can lead to skewed judgments, excessive optimism, unwarranted pessimism or something detrimental to long-term success in investing, i.e., attribution of outcomes to wrong factors.

Importance of base rates in investment decisions

The major contribution of understanding base rates while investing can be seen in avoiding overconfidence and performing asset allocation optimally.

Investors often fall prey to overconfidence, believing they can identify investments or predict market trends with precision. Over-allocating to a stock, sector or segment of market capitalisation or an asset class based on some observations related to recent performance is the most common mistake.

Let’s understand the base rates for guiding asset allocation and consistent performance for a client. The market, as represented by its total market capitalisation, is 61 per cent large and 39 per cent small-and-mid cap. Industry data of flows into equity mutual funds shows investors, by some estimates, have invested nearly 65-70 per cent of the net inflows in the last one year into small-cap, mid-cap and thematic/sectoral funds. However, many certain niches of the market, like railways, infrastructure, defence, etc., may have run up in recent times; the market is still 70 per cent BFSI, IT, Consumer and Industrial stocks, and these hot themes are, at best, some corner, crack or crevice of the market. If your portfolio loses tethering to these base rates, you are primed for a bad experience sooner or later because you are out of sync. If you eat rice like pickle and pickle like rice, there is no point looking for risks in the markets. The risk is in your portfolio; the risk is not in the markets. Ignore base rates at your own peril.

When base rates are neglected, investors underestimate the likelihood of adverse outcomes or overestimate potential gains. For example, investing in niche industries or speculative assets often carries significant risk, yet the perceived novelty or hype surrounding these opportunities may overshadow historical data showing their high failure rates. Recognising base rates ensures that decisions are grounded in reality, reducing susceptibility to undue risk-taking.

It is important to calibrate investments as your outcomes trend further and further from long-term base rates. Watching markets as a continuum and calibrating the pace of investing as well as asset allocation all along that continuum could be more useful than looking for extreme points of the markets and making binary decisions of 100 per cent invested or 100 per cent cash position in or out of any asset class of your asset allocation construct.

Balanced advantage funds, multi-asset funds, and equity savings funds are categories that calibrate equity investment and consider various market levels and valuations in a continuum, which is a good modus operandi for executing this. Avoiding lumpsum investment altogether, except for extreme “blood-on-the-street” panic situations to be taken advantage of, could also be a great tool because the best of intentions and investment plans come under question if one witnesses a significant depreciation of anything more than 10 per cent from the point of entry.

Even the longest of long-term investors would prefer markets moving up after they enter, just as you would like the train to whistle and move onward the moment your luggage is stacked and you take your seat by the window! Investing in liquid or ultra-short-term funds with entry smoothed over a 3, 6, or even 12-month period amidst uncertain circumstances will help one ensure their boat enters the waters with the least turbulence and enables them to stay put, enjoying the sights. After all, we can’t trust a person to be calm and composed once we have seen their anger or emotions under duress, so what if they promise a pleasant disposition for the following 12 months? Base rates matter in observing behaviour, too!

Understanding base rates is not just a matter of statistical literacy—it is a critical skill that empowers investors to navigate complex investment decisions.

Aashish P Somaiyaa spearheads WhiteOak Capital Asset Management Limited as its CEO.

Also read: Think again!