[[Start here]] → [[manage the monkey mind|Mindset]] → Base Rates --- When creating a set of investing rules, you have to understand whether those rules have a positive expectancy. You have to understand their *base rates*. If you don’t, you risk using ineffective rules or worse. What would you answer to this? > Steve is very shy and withdrawn, invariably helpful but with very little interest in people or the world of reality. A meek and tidy soul, he has a need for order or structure and a passion for detail. Is Steve more likely to be a librarian or a farmer?[^1] Most people answer the above question as librarian, even though farmers are at least five times more populous than librarians. This is an example of what’s known as *base rate neglect*, and it’s a mental flaw we can all suffer from. We tend to jump to classify individuals based on how representative they are of a certain stereotype, regardless of how likely that stereotype is (the base rate). This can get very expensive when applied to our money. Let’s take an example in investing: > Star Dynamics Inc is a pre-profit, US listed micro-cap in the engineering sector. The shares have risen 2x in the last six months and there is increasing attention on online forums about a link up with Space X. Is Star Dynamics more likely to be a winner or a loser in the next year? Our instinct is often excitement in a situation like this, but the base rate returns for unprofitable micro-caps are usually quite negative. Our own research suggests that the likelihood of a 1 year gain in scenarios like this can be 2:1 against. Beyond this, in some markets, such as the USA, there are few restrictions that stop PR firms from pumping up the prices of speculative names. Overweighting stereotypes is one of the reasons why [[simple rules beat human judgement]]. If you have come to a realisation that you need to develop a more rigorous process, rather than relying on your own, often faulty, misjudgements, then where do you start? Well in investing, a more sound approach is to start by understanding the base rate returns to classes of shares, then designing selection rules based on them. For example, we may learn that [[good stocks beat junk stocks]] and that the top 20% of highest quality stocks tend to outperform by several percent per year (the base rate). We can then add a rule based on this to our [[use a checklist to improve decision making|checklist]] of buying rules. A rule of thumb often used by quality investors can be to buy higher profitability stocks using the Return on Capital Employed (ROCE) - a ROCE of 18%+ is currently in the top 20% of the market. There lies the cutoff. Then moving on, we may learn that [[low risk stocks beat high risk stocks]], so including a rule to exclude the highest risk stocks in the market makes sense, especially for quality investors. One way to do this is to filter for Beta < 0.5, or to use the RiskRatings on Stockopedia and only include Conservative and Balanced Ratings. As the base rate expectancy of using these two rules is positive, we can have some confidence in applying them. Over the long term, we may find that our portfolio returns are quite satisfactory. The chart below shows a 6% annualised return over a ten year period before dividends. Not thrilling, but a start, and perhaps quite satisfactory for a passive investor seeking a better return than the index.  Using these rules means that *Star Dynamics Inc* is going to be rejected. How does that make you feel? It can be incredibly difficult for many people to stick to a plan, and to forego the excitement of investing in early stage or exciting companies. If that’s you, then you may need to provide yourself a small portfolio allocation towards more speculative stocks. Just remember to keep the allocation small, as otherwise the base rates will dominate and you may have negative returns. If you [[expose to return drivers]] on average over the whole of your portfolio, you are more likely to benefit from the tailwind of the return drivers. Of course, if you are indeed a brilliant stock picker - Star Dynamics may be all you need ;-) [^1]: [[Kahneman - Thinking Fast & Slow]]