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饾悂饾悮饾惉饾悶 饾悜饾悮饾惌饾悶 饾悎饾惂饾惎饾悶饾惉饾惌饾悽饾惂饾悹
Base rate investing is an approach to making investment decisions that rely on statistical data to assess the probability of an investment's success.
This method is based on the concept of the base rate fallacy, which is a tendency in decision-making to ignore base rate information (general information) and focus on specific information (information only about the case at hand).
In investing, this fallacy can lead people to overestimate the significance of recent events or specific news about a company, while underestimating the importance of long-term, general trends. By focusing on base rates, investors aim to correct this bias. They look at how similar investments have performed under similar conditions.
For example, if considering investing in a tech startup, an investor might look at the historical success rate of similar startups in the same industry, at the same stage of development, and possibly in the same geographical area. This base rate then serves as a benchmark to evaluate the expected success of the current investment opportunity.
Base rate investing encourages a more disciplined, data-driven approach, reducing the impact of emotional reactions to market news or events. It aligns with principles found in behavioral finance, which studies how psychological influences and biases affect the financial behaviors of investors.
By considering the base rates, investors can make better decisions, taking into account the broader statistical realities of investment outcomes. This doesn't mean ignoring specific information about the investment opportunity; rather, it means integrating this specific information with the base rates to form a more balanced and comprehensive view of potential risks and returns.
饾悎饾惂饾惉饾悽饾悵饾悶 饾悤饾悽饾悶饾惏 饾惎饾惉. 饾悗饾惍饾惌饾惉饾悽饾悵饾悶 饾悤饾悽饾悶饾惏
Imagine you're trying to guess how many candies are in a big jar. There are two ways you could make your guess:
*饾悡饾悺饾悶 饾悎饾惂饾惉饾悽饾悵饾悶 饾悤饾悽饾悶饾惏: This is like looking at the jar and thinking only about what you see right before you. For example, you might think, "This jar is huge, and candies are small, so there must be many candies in there!" This view focuses on the specific situation and details you're directly observing or know about.
*饾悡饾悺饾悶 饾悗饾惍饾惌饾惉饾悽饾悵饾悶 饾悤饾悽饾悶饾惏: This is like stepping back and thinking about how many candies were in other jars you've seen before that were about the same size. Instead of just thinking about this one jar, you remember, "Last time I saw a jar this big, it had about 100 candies." This view doesn't focus on the jar's details in front of you but on what happened in similar situations in the past.
饾悎饾惂 饾惉饾悳饾悶饾惂饾悮饾惈饾悽饾惃饾惉 饾惏饾悺饾悶饾惈饾悶 饾惀饾惍饾悳饾悿 饾悺饾悮饾惉 饾惁饾悽饾惂饾悽饾惁饾悮饾惀 饾悽饾惂饾悷饾惀饾惍饾悶饾惂饾悳饾悶 饾悮饾惂饾悵 饾惒饾惃饾惍'饾惈饾悶 饾惄饾惈饾悽饾惎饾惒 饾惌饾惃 饾悮饾惀饾惀 饾悳饾惈饾悽饾惌饾悽饾悳饾悮饾惀 饾悽饾惂饾悷饾惃饾惈饾惁饾悮饾惌饾悽饾惃饾惂, 饾惌饾悺饾悶 饾悽饾惂饾惉饾悽饾悵饾悶 饾惎饾悽饾悶饾惏 饾悰饾悶饾悳饾惃饾惁饾悶饾惉 饾惁饾惃饾惈饾悶 饾惉饾悽饾悹饾惂饾悽饾悷饾悽饾悳饾悮饾惂饾惌. 饾悡饾悺饾悽饾惉 饾悽饾惉 饾惉饾悽饾惁饾悽饾惀饾悮饾惈 饾惌饾惃 饾悮 饾惉饾悽饾惌饾惍饾悮饾惌饾悽饾惃饾惂 饾惏饾悺饾悶饾惈饾悶 饾悮 饾悳饾惃饾惂饾悹饾惈饾悶饾惉饾惉 饾惁饾悶饾惁饾悰饾悶饾惈 饾惁饾悮饾悿饾悶饾惉 饾惉饾惌饾惃饾悳饾悿 饾惌饾惈饾悮饾悵饾悶饾惉 饾悰饾悶饾悷饾惃饾惈饾悶 饾惄饾悮饾惉饾惉饾悽饾惂饾悹 饾惀饾悮饾惏饾惉 饾惌饾悺饾悮饾惌 饾惏饾悽饾惀饾惀 饾悮饾悷饾悷饾悶饾悳饾惌 饾惌饾悺饾惃饾惉饾悶 饾惉饾惌饾惃饾悳饾悿饾惉.
饾悅饾惃饾惂饾惎饾悶饾惈饾惉饾悶饾惀饾惒, 饾悽饾惂 饾惉饾悳饾悶饾惂饾悮饾惈饾悽饾惃饾惉 饾惏饾悺饾悶饾惈饾悶 饾惀饾惍饾悳饾悿 饾悺饾悮饾惉 饾悮 饾悹饾惈饾悶饾悮饾惌饾悶饾惈 饾悽饾惁饾惄饾悮饾悳饾惌, 饾悶饾惉饾惄饾悶饾悳饾悽饾悮饾惀饾惀饾惒 饾惏饾悺饾悶饾惂 饾惒饾惃饾惍 饾惀饾悮饾悳饾悿 饾悽饾惂饾惉饾悽饾悵饾悶饾惈 饾悿饾惂饾惃饾惏饾惀饾悶饾悵饾悹饾悶, 饾悽饾惂饾悳饾惃饾惈饾惄饾惃饾惈饾悮饾惌饾悽饾惂饾悹 饾惌饾悺饾悶 饾惃饾惍饾惌饾惉饾悽饾悵饾悶 饾惎饾悽饾悶饾惏 饾悽饾惉 饾悳饾惈饾惍饾悳饾悽饾悮饾惀 饾惌饾惃 饾悹饾悮饾悽饾惂饾悽饾惂饾悹 饾悮 饾惁饾惃饾惈饾悶 饾悳饾惃饾惁饾惄饾惈饾悶饾悺饾悶饾惂饾惉饾悽饾惎饾悶 饾惍饾惂饾悵饾悶饾惈饾惉饾惌饾悮饾惂饾悵饾悽饾惂饾悹.
How does this framework work in practice when analyzing stocks? Well, it鈥檚 quite simple. You can apply this framework to almost every metric/ratio when forecasting a company鈥檚 future.
*You've discovered a young company with a net profit margin of 30%, while the average for its industry hovers around 10%. It's reasonable to anticipate that, over time, this company's net profit margin will move closer to the industry average, unless the company proves to be an exceptional outlier.
*A company is currently trading at 50x Sales. Historically, how frequently have stocks maintained such high trading multiples? And how often did their valuation reverse to the mean?
*A CEO declares an ambitious target to increase sales by 30% annually over the next decade. A standard approach by a Wall Street analyst would involve a detailed bottom-up analysis, examining the company's product lineup, potential market size, and achievable market share. However, a reader of this writing would take a different approach, questioning the feasibility of such growth by comparing it with similar cases in an appropriate reference class, considering factors like the company's current market capitalization, its industry, and the distinctiveness of its product.
*A company is experiencing consistent growth in Free Cash Flow (FCF) year over year, yet its stock price remains stagnant. Typically, since a stock price often aligns with FCF trends, this scenario could present an attractive buying opportunity.
*A company sells exciting software and Wall Street is in love with it and sends the stock higher and higher, but the debt is getting out of control? Guess how this will end? The same way it has ended for all companies that were Wall Street darlings but couldn鈥檛 produce any internal fuel (Free Cash Flow) to keep the business running.
Not only can you apply the base rate to an external reference class, but you can also use it within the company itself. This method has been a part of my toolkit, especially when a company announces initiatives like a "restructuring plan" or a "5-year innovation plan."
We can evaluate their history with similar strategic plans, and check their execution success and forecast accuracy. This approach helps me form a clearer expectation for their current plans. Here, the reference class is the company's management and their track record in similar past situations.
Investing requires a holistic approach. Unfortunately, many investors concentrate too much on the detailed, inside view and overlook the broader, outside view. Blending these perspectives yields the most effective insights because it offers a comprehensive view of a company. This underscores the importance of understanding stock market history for investment success.
New investors often seek quick results, not recognizing that building knowledge and experience takes time. It's after several years that you'll become adept at forecasting a stock's movement, thanks to your accumulated experiences (your reference group).
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