[MUSIC] Learning outcomes, after completing this video you'll be able to explain what base rate neglect representative bias means, understand the different ways in which basic neglect can be avoided. Representation bias, base rate neglect. Investors, in order to derive meaning from financial markets, develop, or have developed an innate propensity to classify trades and trade ideas, just slotting them into bins. When they confront a new market situation that's inconsistent with what they already know and is inconsistent with any of their preconstructed classifications or bins, investors typically subject it to those prior classifications, relying on a rough best fit approximation to determine which category should house what. And therefore, form the basis for their understanding of this new market situation. This perpetual framework provides a very fast tool, a very quick tool for processing new information and data from financial markets by simultaneously incorporating insights gained from past trading experiences. However, in reality, financial markets may have had a paradigm shift as, for instance, the way it happened in the financial crisis. In such a situation, the classifications of these new financial markets' behavior leads to deception or incorrect representation, and therefore, investors use incorrect understanding of this new market situation. What you're trying to do is to classify something that's happening now into your preconceived notions of fits, and slot them into your framework. This often tends to bias investors' future trading strategies, which kind of doesn't incorporate this new structural change. Now let me give an example of a basic neglective representative bias. Let's say there are two investor friends, Tom and Jerry. Tom is an investor who is looking to add to his portfolio and hears about a very good potential investment through his good friend Jerry at a local coffee shop. And let's say the conversation goes something like this, Tom says, hi, Jerry, my portfolio is really suffering. I could use a little bit of advice on a good long term investment. Have you got any ideas? Then he says, well, Tom, I've heard of a great, new, IPO, or pharmaceutical company, called Pharmacruit that, came out just last week. Now, Pharma Growth is a very exciting company, hot new company that should be a great investment. >> Its president and CEO was a mover and shaker in an Internet company that did great during the tech boom in 2000, and I expect that this particular president and CEO will have Pharma Growth growing by leaps and bounds. >> And Tom gets excited and goes, well, I haven't heard of this firm called Pharma Growth, tell me more. And Jerry says well, the company markets a generic drug sold over the Internet for people with a particular stomach condition that a lot of people have, and Pharma Growth offers online advice in addition to stomach health. A lot of Wall Street firms have issued a buy rating on this particular stock. Hearing this, Tom says, wow, that sounds like a great investment. And Jerry says, well, I bought some. I think it could do extremely well. So Tom says, okay, I'll buy some, too. And then Tom just pulls out his mobile phone and calls his broker and places an order for a very large number of shares of this firm called Pharma Growth. This new IPO as necessarily representative of an extremely good long term investment which it may not be. Many investors like Tom believe that IPOs make a very good long term investment due to all the upfront hype that surrounds IPOs in the media and in the financial press. In fact, research has shown that a very low percentage of IPOs actually turn out to be good long-term investments. And this common investor misconception is likely due to the fact that investors in these exciting hot new IPOs usually make money in only the first few days after the offering. Over time, however, these stocks tend to trail their IPO prices, and a lot of times never go back to their original levels. Well, there's a relatively fairly easy way to analyze how an investor could fall prey to this base rate neglect and let me give you an example. Let's say, for instance, you have a new person joining your firm. And let's say that he's very shy and introverted. Suppose you are asked to bet on what his hobbies may be. And you're given just two choices, he's a stamp collector, and he's excited about Formula One racing. Now if people in general were asked this question, a lot of people would answer by evaluating the degree to which this particular person represents a stamp collector or a F1 fan. Considering that this particular new colleague who has joined your firm is shy and introverted, It may seem that he's more representative of a stamp collector than an F1 fan. This approach kind of reflects basic neglect, because statistically, far more people are F1 fans than stamp collectors. Like in this example, where we slotted people into two groups, stamp collectors or F1 fans, our hypothetical investor, Tom, has effectively basically kind of slotted Pharma Growth. This new hot IPO belonging to either a group of stocks that constitutes successful long term investment, or the other group that failed as long term investments. Let us call the group of stocks constituting successful long-term investments as a group similar to stamp collectors, and the group of stocks that fail as long-term investments as similar to F1 fans. A lot of investors would approach the investment problem by attempting to find out the extent to which this particular hot new IPO appears characteristically representative of the first group of stocks, or the second group. In Tom's judgment, Pharma Growth possesses the properties of a successful long term investment. The first group, rather than the second group, which are basically failed long term investments. Any investor arriving at this conclusion, however, ignores the base rate fact that IPOs are more likely to fail than to succeed. So basic neglect bias is the attempt by investors to determine the potential success of an investment in a company by contextualizing the investment in easy-to-understand bins and familiar classifications like, for instance, IPOs make money. Now this reasoning, however, tends to ignore other variables that could substantially impact the success of the investment. So investors often embark on this mistaken path because it looks like an alternative to diligent research that is actually required when you are evaluating an investment. To summarize, in this characterization some investors tend to rely on stereotypes when making investment decisions. So what is the solution for the base rate neglect representativeness bias and how to avoid it? A very effective method for dealing with basic neglect is if I, as an investor, sense that basic neglect could be a problem, I should perform the following analysis. What is the chance that the hot new IPO could fall in the category of stocks that do not perform well rather than stocks that are actually very, very successful IPOs? It's the same thing as asking the question that the new employee that's joined the organization is more likely to be a F1 fan than a stamp collector because statistically it's more likely that it will be the first category rather than the second category. Recalling this example will help investors like me think through whether I have mistakenly or erroneously assessed a particular investment situation. It may likely be necessary for me to go back and do more research to determine if I'm indeed committing a base rate neglect error. This process of analyzing can improve and can prove beneficial in helping me make better. [MUSIC}
