Base Rates

• The Bottom Line: Using the historical success and failure rates of similar situations (the “base rate”) to ground your investment forecasts in reality, preventing you from being seduced by a unique-but-unlikely story.
• Key Takeaways:
• What it is: The “outside view,” or the statistical average outcome for a broad category of companies or events (e.g., the historical failure rate of new restaurants).
• Why it matters: It's the single best antidote to investor overconfidence and the powerful, seductive narrative that “this time is different.” It's a core tool of behavioral_finance.
• How to use it: By identifying a relevant “reference class” for a potential investment and using its historical data as a starting point for your analysis.

Imagine your enthusiastic friend, Alex, tells you he's quitting his job to open a gourmet burger restaurant. He has a charismatic personality, a secret sauce recipe from his grandmother, and has found the “perfect” location downtown. He shows you a detailed business plan projecting huge profits within two years. This is the “inside view”—all the specific, compelling details of this single situation. It's easy to get swept up in the excitement and believe Alex's restaurant is destined for greatness. Now, take a step back. Instead of focusing on Alex's secret sauce, you ask a different question: “Historically, what percentage of new restaurants fail within the first five years?” The answer, you discover, is somewhere around 60-80%. This sobering statistic is the base rate. It's the “outside view”—the average outcome for a large group of similar ventures (the “reference class”) that came before. A base rate is simply the statistical track record of a particular class of events. It ignores the “unique” details of the specific case in front of you and instead relies on the cold, hard data of history. This concept was popularized by psychologists Daniel Kahneman and Amos Tversky, who found that humans are psychologically wired to overvalue the inside view (the story) and systematically ignore the outside view (the statistics). ¹⁾. For an investor, falling for this trap—known as “base rate neglect”—can be catastrophic. You fall in love with a company's story, its visionary CEO, or its “revolutionary” product, while completely ignoring the fact that 9 out of 10 companies with similar profiles have historically failed. Using base rates doesn't mean you automatically dismiss Alex's restaurant or that hot tech startup. It means you use the historical average as your starting point, your anchor to reality. From there, you can rationally assess whether Alex's specific advantages are truly powerful enough to overcome the daunting odds.

“If you're in the luckiest 1 percent of humanity, you owe it to the rest of humanity to think about the other 99 percent.” - Charlie Munger

While Munger's quote is about social responsibility, its statistical logic is a perfect parallel for base rate thinking. If you only focus on the 1% of startups that become unicorns, you will develop a dangerously distorted view of reality. A value investor must always think about the other 99%.

For a value investor, thinking in base rates isn't just a neat mental trick; it is a fundamental pillar of rational decision-making and risk management. The entire philosophy of value investing is about replacing emotional reactions and speculative narratives with objective analysis. Base rates are a primary weapon in that arsenal.

• It's the Antidote to “Story Stocks”: The market is filled with compelling stories about companies that are “changing the world.” These narratives are the engine of speculative bubbles. A base rate thinker immediately asks, “Of the last 100 companies that promised to 'change the world' in this industry, how many actually succeeded and generated sustainable profits for shareholders?” The answer provides a crucial dose of skepticism and grounds the analysis in facts, not fantasy. This is a direct path to avoiding permanent loss of capital.
• It Informs the Margin of Safety: The required margin of safety is not a static number; it should be directly proportional to the risk and uncertainty of the investment. Base rates help you quantify that uncertainty.
  • If you're analyzing a regulated water utility (a business model with a very high historical success rate), your required margin of safety might be relatively modest.
  • If you're analyzing a biotechnology company with a single drug in Phase II trials (a venture with an overwhelmingly high historical failure rate), your required margin of safety must be immense to compensate for the dreadful odds. Ignoring the base rate here is financial suicide.
• It Reinforces the Circle of Competence: A true circle of competence isn't just about understanding how a business works. It's about deeply understanding the industry's economics and its historical patterns of success and failure. In other words, you intuitively know the base rates. When Warren Buffett says, “Turnarounds seldom turn,” he is articulating a base rate he has observed over decades of experience. He knows that the historical probability of a deeply troubled company successfully reinventing itself is very low, so he largely avoids them, no matter how compelling the new CEO's story is.
• It Combats Human Psychology: We are all susceptible to optimism bias, overconfidence, and the allure of a good story. We want to believe we've found the “next big thing.” Base rates act as a circuit breaker for these emotions. They force you to step outside your own head and confront the objective track record of others who have walked a similar path. It moves you from “I feel this is a winner” to “The data suggests the probability of success is X%, and here's why I believe this company can beat those odds.”

Applying base rates is more of an art than a science, as it involves a mindset shift rather than plugging numbers into a formula. It's a qualitative discipline that dramatically improves quantitative analysis.

Here is a step-by-step process for incorporating base rate analysis into your investment process:

1. Step 1: Identify the Core Question. What are you really trying to predict? Are you assessing the likelihood that a growth company will maintain a 30% growth rate for ten years? Are you evaluating the probability of a successful corporate merger? Or are you analyzing the chances of a cyclical company surviving a deep recession? Be specific.
2. Step 2: Define the Reference Class. This is the most crucial and most difficult step. You need to find a group of past situations or companies that are genuinely comparable.
   • Too Broad: “All tech stocks.” This is not very useful.
   • Too Narrow: “Software-as-a-Service (SaaS) companies founded in Austin, Texas, by left-handed CEOs.” This is useless as you'll have no data.
   • Just Right: “SaaS companies that reached $50 million in annual recurring revenue.” Or “Retail companies that attempted a major strategic turnaround after losing 50% of their market share.” The goal is to be specific enough to be relevant but broad enough to have a meaningful sample size.
3. Step 3: Research the Base Rate. Go find the data. This requires work. You may need to look at industry reports, academic studies, financial data providers, or even read business history books. What happened to the companies in your reference class?
   • What was their average return on invested capital over the next decade?
   • What percentage were acquired?
   • What percentage went bankrupt?
   • What percentage saw their margins shrink back to the industry average? (A nod to mean_reversion).
4. Step 4: Analyze the “Inside View”. Now, and only now, should you focus on the specifics of your target company. What are its unique advantages or disadvantages compared to the reference class? Does it have a deeper competitive moat? Is its management team significantly more skilled and aligned with shareholders? Is its balance sheet much stronger?
5. Step 5: Calibrate Your Forecast. Start with the base rate as your anchor. Then, cautiously adjust your expectations up or down based on your inside view analysis. If the base rate for long-term profitability in an industry is 20%, you shouldn't forecast a 90% chance of success unless you have overwhelmingly powerful evidence that the company is a true outlier. The base rate forces you to justify your optimism with facts.

The “result” of a base rate analysis isn't a single, magic number. It is a more realistic and probabilistic view of the future. It prevents you from making extreme forecasts (either overly optimistic or overly pessimistic) that are not supported by historical precedent. A low base rate for success doesn't automatically mean “don't invest.” It means the bar for investment is set extraordinarily high. It tells you that the story better be exceptional, the intrinsic value significantly higher than the price, and the margin of safety massive. Conversely, a high base rate for success (e.g., in a stable, oligopolistic industry) can give you the confidence to invest even when the story isn't as exciting.

Let's say a friend who works in venture capital pitches you an investment in “AeroVolt,” a startup developing electric vertical take-off and landing (eVTOL) aircraft—essentially, flying cars. Here is how an “inside view” analysis clashes with a “outside view” (base rate) analysis.

The base rate analysis doesn't require you to be an expert in battery chemistry or aerodynamics. It simply requires you to acknowledge history and the brutal economics of the industry. It protects you from the powerful narrative and anchors your decision in statistical reality.

• Combats Cognitive Biases: It is a direct countermeasure to some of the most powerful and destructive investor biases, namely overconfidence, optimism bias, and the planning fallacy (our natural tendency to underestimate the time and cost of future projects).
• Improves Risk Assessment: It provides a quantitative starting point for understanding the risks involved, leading to a more rational calculation of the required margin_of_safety.
• Anchors Projections in Reality: It prevents financial models from becoming fantasy documents by forcing forecasters to justify why their projections deviate significantly from historical norms.
• Encourages Humility: It reminds us that a situation that feels unique and special is usually just another instance of a common pattern. This intellectual humility is a hallmark of great investors.

• Defining the Reference Class is Subjective: The biggest challenge is selecting the right reference class. A poorly chosen class can provide a misleading base rate. This step requires careful judgment.
• Data Can Be Hard to Find: For niche industries or new technologies, finding reliable, long-term data to establish a base rate can be difficult or impossible.
• The Past is Not Always Prologue: In rare cases, a truly revolutionary change (like the internet) can break from past patterns, making historical base rates less predictive. Value investors must be alert to these paradigm shifts without being fooled by the many false alarms.
• Misinterpreting Probability as Destiny: A base rate is a probability, not a certainty. Unlikely events happen. A low-probability outcome can still occur, and a high-probability one can fail. The goal is not to predict the future perfectly but to bet when the odds are heavily in your favor.

• margin_of_safety
• behavioral_finance
• circle_of_competence
• mean_reversion
• speculation
• mr_market
• intrinsic_value