Posted by airsafe in Psychology on 04 24th, 2008 | 5 responses

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Several years ago, a friend of mine put two thousand dollars into Owens-Corning stock. Not long after, he took out his original investment, leaving what he had earned; a year or so after that, he took out twenty-five hundred dollars of pure profit. “I want to do that!” I thought, and bought some stock. It tanked. What did I do wrong? Partly I didn’t research my choices enough; but mainly, I used my friend’s experience to decide my actions when I should have thought harder about the numbers involved.

People are much more likely to die in a car crash (or on a bicycle) than in a plane crash. But after 9/11, more than a million people decided plane travel was too risky, and many of them drove instead of flew–and some of them died. (See this article on how driving fatalities increased after September 11, 2001.) Most people, if pressed, know that driving is more dangerous than flying. Most of the people who decided not to fly after 9/11 probably knew this too. Why did they make the choice they did? For the same reason I bought stocks without studying how they were likely to do: the base-rate fallacy.

The base-rate fallacy is a cognitive heuristic, a rule of thumb for making quick judgments. We use cognitive heuristics for processing information in fast bursts. This was good for us back when we were living in the wild in small groups, surrounded by threats; it’s not as useful now, when we live in modern, safe, diverse civilization. We have a whole new set of problems. But cognitive heuristics are hardwired into our brains, and they haven’t caught up with modern times.

The base-rate fallacy means that people don’t pay real attention to probabilities or base rates–even when they know they’re important. Instead, we care about dramatic events, pictures or visceral moments–like seeing a plane crash into the World Trade Center. One picture is worth a thousand statistics.

In essence, we like faces better than numbers. This makes sense considering our primate roots: immediate, dramatic events, especially events happening to other people, are important and will probably affect us; abstract ideas probably will not.

But in today’s modern life–and especially in the realm of personal finance–it’s important not to let this fallacy trip you up. Maybe you just read an article about someone who bought Google as a penny stock and is now a millionaire, but that doesn’t mean you should buy penny stocks from Unknown Company X–or that you should put money in the stock market just because your friend did. The image of being like that millionaire is a pleasing one, but the numbers are against you.

How do you fight the base-rate fallacy? Take a moment to think, rather than react, and remember that–adages aside–personal influence will lead you awry more often than statistics will. If you’re finding it hard to concentrate on the numbers, try to think about statistics in a visual, relevant way. You have a 1 in 17 million chance of winning the lottery? If you drove through the entire state of Florida and personally saw every person who lived there, only the last person you met would be a lottery winner. Your bank is offering a 5% five-year CD? If you invested your $10,000 savings, the extra money will pay for a month’s lease of a Lexus or two nights in Las Vegas (one if you gamble it away).

Our brains are good processing machines–sometimes too good. But that doesn’t have to hold you back. Pay attention to events, to people, to the stories that grab you; but don’t forget that the numbers will tell you the truth–and the truth is more important than a story.

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Tags: base-rate fallacy, cognitive heuristics