Don't Ignore the Base Rate

Suppose you were presented with a panel of 100 participants: 70 nurses and 30 librarians. Each participant has a personality description for you to read. Randomly, you choose a participant with the following description:

“Nancy is an introvert. She likes to read and is well organized. She is also the president of her local book club.”

Giving your best guess, is Nancy a nurse or a librarian?

If your answer was librarian, you committed what is known as “Base Rate Neglect.” Although Nancy has certain characteristics which are associated with a librarian, choosing librarian in this example would only garner a 30% chance of success (because only 30 out of the 100 participants are librarians).

Investors tend to extrapolate recent news into high likelihood events. For example, the drumbeat of a recession and associated bear market was loud during the 4th quarter of 2018.

Below is the “Fear & Greed Index” from December 21, 2018 produced by CNN Money. As we neared the end of the calendar year 2018, the market was pricing in what looked like a worst-case scenario — impending economic slowdown, bear market, and recession.

Although the potential of poor economic data and bear market occurrences always persist, it would be ignoring the base rate.

Below is data back to 1928 for the S&P 500, which outlines positive and negative returns over rolling periods – from 1 day to 25 years.

Over every 1 year rolling period since 1928, the S&P 500 has been positive 72% of the time. So, if I were to ask you whether the S&P 500 will be positive one year from now, are you choosing the nurse or the librarian?

Sources:

https://money.cnn.com/investing/about-fear-greed-tool/index.html

S&P 500 data source: Ken Fisher