Poke the Box: Make a Ruckus, Take Risks…but Remember Base Rates

Mental Model of the Week: Base Rates

I heard this recently in a radio ad of a leading insurance company – “For every minute you are stuck in the traffic, we settle five claims.”

Sounds great, right? Five claims in one minute is quite a number.

“But, five out of how many claims that you receive, sir?” I wanted to ask. When I got back home and checked the claim-settlement number, it was around 70%! Now that’s poor!

“There is nothing more deceptive than an obvious fact,” said Sherlock Holmes.

Then, Bertrand Russell said, “Obviousness is always the enemy to correctness.”

It happens so often in life that we come out with wrong conclusions because they seem the obvious based on a single observed effect.

When someone remarked to the French writer Voltaire, “Life is hard,” he retorted, “Compared to what?”

We tend to ignore alternatives, and therefore we fail to make appropriate comparisons. Often we only consider information or evidence that is presented or available and don’t consider that information may be missing.

In effect, we ignore the base rates, which simply mean that if 1% of the public were “medical professionals”, and 99% of the public were not “medical professionals”, then the base rate of medical professionals is simply 1%.

In the same way, if 2% of penny stocks earn good long-term return, and 98% don’t, then the base rate of success in penny stock investing is just 2%.

Here is what Prof. Sanjay Bakshi said in his interview with Safal Niveshak…

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One of the great lessons from studying history is to do with “base rates”. “Base rate” is a technical term of describing odds in terms of prior probabilities. The base rate of having a drunken-driving accident is higher than those of having accidents in a sober state.

So, what’s the base rate of investing in IPOs? When you buy a stock in an IPO, and if you flip it, you make money if it’s a hot IPO. If it’s not a hot IPO, you lose money.

But what’s the base rate – the averaged out experience – the prior probability of the activity of subscribing for IPOs – in the long run?

If you do that calculation, you’ll find that the base rate of IPO investing (in fact, it’s not even investing…it’s speculating) sucks!

That’s the case, not just in India, but in every market, in different time periods.

What you don’t see can really kill you! And people don’t see the base rates.

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When you evaluate whether smoking is good for you or not, if you look at the average experience of 1,000 smokers and compare them with a 1,000 non-smokers, you’ll see what happens.

People don’t do that. They get influenced by individual stories like a smoker who lived till he was 95. Such a smoker will force many people to ignore base rates, and to focus on his story, to fool themselves into believing that smoking can’t be all that bad for them.

What is the base rate of investing in leveraged companies in bull markets?

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By the way, here are some base rates of dying for different reasons (as per the US National Center for Health Statistics)…

• Hand gliding – 1 in 560
• Grand Prix racing – 1 in 100
• Motorbike racing – 1 in 1,000
• Mountain climbing – 1 in 1,750
• Bicycling – 1 in 140,000
• Running/Swimming– 1 in 1 Million (1 Million = 10 Lac)
• Car driving – 16 in 100,000 drivers
• Motorcycle riding – 21.5 in 100 million vehicle miles
• Airplane – 1.3 deaths in 100,000 flight hours
• Smokers – 22x more likely to die of lung cancer than non-smokers
• Lifelong smokers – 50% die before age 70
• Dance parties – 1 in 100,000

Finally, regardless of all risks, your probability of dying during a given year doubles every 8 years!

So watch out for base rates before making any decision in life (and investing), and please be careful.

Poke of the Week – Take Risks

The leading American entrepreneur, author and public speaker Seth Godin has had a great influence on my life as a writer and thinker.

In his recent book titled The Icarus Deception, Seth writes about the story of Icarus, whose father Daedalus fashioned two pairs of wings out of wax and feathers for himself and his son to fly out of a prison they were captivated in.

Daedalus tried his wings first, but before taking off from the island, warned his son not to fly too close to the sun, nor too close to the sea, but to follow his path of flight. However, overcome by the giddiness that flying lent him, Icarus soared through the sky curiously, but in the process he came too close to the sun, which melted the wax.

Icarus kept flapping his wings but soon realized that he had no feathers left and that he was only flapping his bare arms, and so he fell into the sea.

The Icarus myth is often used as an example of when hubris or over-confidence – of flying too high – can go badly wrong.

However Seth, in his book, points out that there is another part of the story – Icarus’s father Daedalus also told his son not to fly too low as the water could also damage his wings.

As per Seth – “Society has altered the myth, encouraging us to forget the part about the sea, and created a culture where we constantly remind one another about the dangers of standing up, standing out, and making a ruckus.”

However, he writes, settling for too little is “a far more common failing”.

You see, we all have the potential to do great work in life. However to do so, we need to leave our comfort zones – to fly closer to the sun, and to fail sometimes.

If you’re not failing every now and again, it’s a sign you’re not doing anything very innovative.

Looking from another angle, if you’re hitting bull’s-eye every time, maybe you’re standing too close to the target.

Like when it comes to investing, I have a long list of great stocks that I did not buy or sold early, for a simple reason that I feared taking some risk.

But since these errors of omission won’t show up in my profit and loss account, I often ignore them.

The reality is that our errors of omission – not flying high and close to the sun – can be more costly than the errors of commission – flying too close to the waters.

Thankfully, what I omitted – taking risks – in my investing life, I committed in my work life, and that led me to quit my job to pursue my passion.

Ask yourself what stops you from taking risks in your life – not risks based on arrogance and blind overconfidence, but well-calculated risks like…

• Building up a saleable skill that people would pay for, and then telling your boss that you won’t need his services soon
• Telling your boss how his excel-based projections could go haywire
• Starting a business that you have been wanting for years
• Researching businesses and then investing in them independently
• Spending time learning a third, or a fourth language
• Learning how to swim or drive…or cook

Arthur Koestler put it so well – “If the Creator had a purpose in equipping us with a neck, he certainly would have meant for us to stick it out.”

Just answer this question – “What would our world look like if more people moved out of their comfort zones, made a ruckus, and took risks to change their and others’ lives?”

Maybe this could be your permission slip.