Base Rate Neglect — A common fallacy
Let’s say there is an outbreak of a certain disease in your town.
For simplicity, let’s assume the population of the town is 100 people and occurrence of the disease is 10% i.e. 10 out of the 100 people have the disease.
You don’t show any symptoms but still decide to go for a test. To your shock the test turns out positive. The test has an accuracy of 90% which means it detects 90 of out 100 people accurately.
What are the chances that you have this disease, 90% right?
Let’s do the numbers.
Since the test accuracy is 90%, it will identify 9 out of the 10 infected people as positive and 81 out of the 90 non-infected people as negative.
Now, you are in the “Tested Positive” category highlighted in yellow below.
The chances you have the disease given you tested positive are actually 50% i.e. 9/18 and not 90% as you earlier thought.
This is a very common fallacy where you neglect the base rate of disease prevalence i.e. 10% but give more importance to specific information i.e. testing positive.
Base Rate Neglect is pretty common in investing decisions where you tend to invest in a stock based on some very specific events while ignoring the underlying fundamentals of the business or sector.
It is important to factor in the base case scenarios before drawing any conclusions and taking decisions.
Have you ever been a victim of Base Rate Neglect?
