Base Rate Fallacy

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, it is the tendency for people to erroneously judge the likelihood of a situation by not taking into account all relevant data and focusing more heavily on new information without acknowledging how the new information impacts the original assumptions.

BREAKING DOWN 'Base Rate Fallacy'

When an investor exhibits base rate neglect, he does not (neglects to) consider the probability that new information does, in fact, fit the category into which it has been placed, and thus he places too little weight on the base rate. This can be explained in terms of Bayesian statistics where an individual forms probabilities or base rates. With the receipt of new information, a rational investor updates those probabilities to reflect the new information. When subject to base rate neglect, however, too little weight is placed on on the base rates (prior probabilities) and too much on the new information. The opposite effect also is a common cognitive error, known as the conservatism bias, whereby the base rate is overly weighted.

For example, Bob is an avid opera fan who enjoys visiting art museums and historic sites when he is on vacation. Growing up, Bob liked to play chess with friends and family, and his favorite movie was The Sound of Music. Which situation is more likely?

A) Bob plays first violin for a major symphony orchestra.
B) Bob is a lawyer.

The majority of people are inclined to judge that Bob is much more likely to be the musician even though it is much more probable that he is a lawyer. The characteristics described in his description are perceived as more representative of people employed in the arts. However, a quick look at some statistics show the base rate fallacy. There are more than 1.5 million lawyers in America and only a very small handful of first-chair violinists for a major orchestra.