The Psychologist Who Turned the Investing World on Its Head: Base Rates and Cognitive Illusions

The Psychologist Who Turned the Investing World on Its Head: Base Rates and Cognitive Illusions

In the world of investing, there is a constant search for the next big idea or strategy that will lead to success. However, one psychologist, let's call him Danny, has turned the investing world on its head with a simple concept - base rates. According to Danny, the most important question to ask before making any decision is, "What is the base rate?"

To understand what Danny means by this, let's take the example of starting a new business. Your gut feeling might tell you that your business idea is foolproof and will undoubtedly succeed. However, if we look at the base rate, we find that half of all new businesses fail within the first five years according to the Bureau of Labor Statistics. This base rate is derived from millions of startups, each of which also believed they would succeed. It's essential to recognize that while the base rate is 50/50, you are a sample of one.

Knowing the base rate shouldn't deter you from pursuing your business idea, but it should prevent you from being unrealistically optimistic. Danny himself applied this concept to his personal life when proposing to his second wife, Anne Treisman. He acknowledged the base rates of divorce and the differences between them, such as their religious and personality backgrounds. By recognizing the base rates, he was able to approach the decision with a more realistic perspective.

Danny's understanding of base rates goes hand in hand with his belief in cognitive illusions. As a researcher in visual perception, he knew that just as optical illusions fool the eye, cognitive illusions fool the mind. This knowledge led him to conclude that trying to outsmart the market or believe that he could see what others couldn't was an illusion. Instead, he took a more passive approach to investing, putting most of his money in index funds. He believed that making fewer decisions and avoiding the temptation to be clever would make him a better investor.

Now, let's shift our focus to the world of economics and the recent layoffs in the fast-food industry. Pizza Hut franchisees in California have laid off more than 1,200 delivery drivers as they prepare for the potential impact of $20 fast-food wages. This news highlights the challenges faced by businesses in adapting to changing economic conditions and labor costs. However, it's important to note that most of the layoffs that have occurred in the past two months aren't reflected in current data.

Here, we find a connection between Danny's concept of base rates and the challenges faced by businesses. Just as Danny emphasized the importance of understanding the objective odds of success based on historical outcomes, businesses must also consider the base rates when making decisions. The fast-food industry, for example, must navigate the potential impact of higher wages on their operations and profitability. By understanding the base rates and historical trends, businesses can make more informed decisions.

Now, let's transition from understanding these concepts to taking action. Here are three actionable pieces of advice derived from the ideas discussed:

• 1. Consider the base rates: Before making any major decision, whether it's starting a business or investing in the stock market, take the time to understand the base rates. Look at the historical outcomes in similar situations and assess the objective odds of success. This will help you avoid being unrealistically optimistic and make more informed decisions.

• 2. Beware of cognitive illusions: Just as optical illusions can fool the eye, cognitive illusions can fool the mind. Be aware of the biases and cognitive traps that can cloud your judgment. Avoid the temptation to outsmart the market or believe that you have unique insights that others don't. Instead, take a more passive and disciplined approach to investing.

• 3. Adapt to changing economic conditions: In a rapidly changing economic landscape, businesses must be agile and adapt to new challenges. Consider the potential impact of factors such as wage increases and changing consumer preferences on your operations. By staying informed and proactive, businesses can position themselves for success in the face of uncertainty.

In conclusion, the ideas presented by Danny, the psychologist who turned the investing world on its head, offer valuable insights for both investors and businesses. Understanding base rates and avoiding cognitive illusions can lead to more informed decision-making. By taking a disciplined approach and adapting to changing economic conditions, individuals and businesses can increase their chances of success. So, the next time you face a major decision, remember to ask yourself, "What is the base rate?"