DEFINITION of 'Base Rate Fallacy'

Base rate fallacy, or base rate neglect, is a cognitive error whereby too little weight is placed on the base (original) rate of possibility (e.g., the probability of A given B). In behavioral finance, base rate fallacy is the tendency for people to erroneously judge the likelihood of a situation by not taking into account all relevant data. Instead, investors might focus more heavily on new information without acknowledging how this impacts original assumptions.

BREAKING DOWN 'Base Rate Fallacy'

Two categories of information exist when determining probability in many situations. The first is general probability; the second is event-specific information, such as how many basis points the market has shifted, what percentage a company is off in its corporate earnings, or how many times a company has changed management. Investors often tend to give more weight to this event-specific information over the context of the situation, at times ignoring base rates entirely.

While often event-specific information is important in the short-term, particularly for traders or short-sellers, it can loom larger than it needs to for investors attempting to predict the long-term trajectory of a stock. For example, an investor may be trying to determine the probability that a company will outperform its peer group and emerge as an industry leader. While the base of information – the company's solid financial position, consistent growth rates, management with proven track records, and an industry with strong demand – all points to its ability to outperform, a weak earnings quarter could set investors back, making them think that this is changing the company’s course, while in fact it could simply be a small blip in its overall rise.

Base Rate Fallacy and Behavioral Finance

Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.

According to conventional financial theory, the world and its participants are, for the most part, logical "wealth maximizers." However, many instances exist in which emotion and psychology heavily influence investor decisions, causing people to behave in unpredictable ways.

With strong ties to the concept of base rate fallacy, overreaction to a market event is one such example. According to market efficiency, new information should rapidly be reflected instantly in a security's price. Reality, however, tends to contradict this theory. Often, market participants overreact to new information, such as a change in interest rates, creating a larger-than-appropriate effect on the price of a security or asset class. Such price surges are not usually permanent and tend to erode over time.

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