What if you know nothing about the future? Start with base rates!
September 15, 2014
Let’s start with a little exercise:
There are 20 times more farmers than librarians in the US. Steve comes from the US. He is very shy and withdrawn, invariably helpful but with little interest in people or in the world of reality. A meek and tidy soul, he has a need for order and structure, and a passion for detail. Is Steve more likely to be a librarian or a farmer?
We shall return to this question shortly.
Growth and Fixed Mindsets
According to Prof Carol Dweck of Stanford University, there are two types of people: those with a fixed mindset, and those with a growth mindset. Growth mindset people are very comfortable with uncertainty; they can navigate the changes in the environment with ease using a combination of foresight, risk management and avoidance, and experimentation. To them, life is a learning journey so they try to learn as much as they can by taking small, calculated risks. To the fixed mindset people, life is a test, so they’d have to do well. Because they have to do well, they need to be sure about where to place their bets. They rely on studies and data analysis to gain assurance. When there is no data to be found, they will defer action until there is clarity. This can make progress slow and they compensate that by working on bigger projects with larger payoffs.
Since both these mindsets relate to uncertainty so differently, they may both take on a risky project differently; growth mindset people may be too optimistic and fixed mindset people too pessimistic. There must somehow be middle ground between the two, and there is; it is called base rates.
Of biases and base-rates
According to Prof Daniel Kahneman who designed the question we opened this article with, as featured in his book Thinking, Fast and Slow, you will be more likely to answer that Steve was a librarian. In fact, when we asked this same question in our critical thinking workshops, we had more than 70% of participants saying that Steve was more likely to be a librarian.
Unfortunately, that is incorrect. Steve was more likely to be a farmer; the answer was stated in the beginning of the question: “There are 20 times more farmers than librarians in the US.” The description of Steve was superfluous, because it was sufficiently vague to be equally applicable to both a librarian as to a farmer. Unfortunately, we are normally biased to think that librarians are introverted souls with a need for order while farmers are more boisterous, and we accrue more credence to our biases than we do to base-rates.
A base-rate is therefore the most granular result of an outcome based on the Law of Large Numbers. For example, someone asked me before the World Cup started this year if Brazil would win. Of course no one can know for sure. However, when I looked at the number of times the host nation won the world cup, it turned out to be 6 out of the 19 times it had been played previously. This means that there is a less than one-third chance that Brazil would win, based on past results. So I said no. And it turned out to be true. So, when we don’t have any way of predicting the future, we need to rely on base-rates to make a prediction, ignoring our biases, ignoring what our gut tells us and ignoring our preferred option.
So, let’s test your decision making ability now:
1. According to Forbes magazine, 8 out of every 10 startups fail within 18 months. You are thinking of starting up. What is the likelihood that you will remain in business two years from now? What should you do about this?
2. According to Medscape, 56 percent of US doctors surveyed in 2012 admit they regret becoming a doctor (the percentage was 31 percent in 2011). If you were making a career choice and contemplating starting medical school, racking up a huge student loan and taking 8 years to come on stream, what likelihood will you remain happy in the job in 10 years’ time? Should you be making this decision now?
3. The National Endowment for Financial Education in the US estimates that 70 percent of people who come into a windfall lose all their money within a few years. With this in mind, how successful will you be in handling your own CPF monies when you withdraw it after age 55? Does that mean it is better to have a higher minimum sum?
We overestimate our abilities
The Dunning-Kruger effect is a cognitive bias that affects unskilled individuals, giving them a false sense of competence. In other words, they tend to over-estimate their abilities in handling issues that they are not skilled in doing. So they tend to believe that they can do better than the market in picking stocks, in answering a question on Jeopardy, in winning the Indy500, in just about anything! So be aware. Don’t fall into this trap. When you are faced with uncertainties and you are none the wiser for it, search for base-rates. They are more accurate than you think.
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