Explaining base rate neglect.
For a real life example, take the $50 opportunity currently offered by insurance giant AIG to provide you “FlightGuard” coverage that guarantees a $500,000 payout to your beneficiary in the event your flight crashes and you die. This means every 10,000 flights without loss of life AIG will make a profit.
Now using the base rate we can calculate the extent to which $50 for $500k in coverage is a fair offer. The actual odds that you will die in a plane crash are approximately 1 in 11 million. Based on this base rate, over time AIG is making slightly more than 1,000 times the money they will pay out. Indisputably this is a horrific deal for the consumer. In fact, it is such a bad deal that you would be much better off taking that same $50 and buying fifty lottery tickets in the “Texas Lotto”. The minimum you can win in the lotto is $4 million, 8x the insurance payout. And your odds of winning with 50 tickets are roughly 1 in 500,000 or 22x higher than the odds of dying in a plane crash. Now I’m not saying playing the lottery is a great deal either, but using the base rate I can definitely tell you it is a deal approximately 175x better than buying “FlightGuard” insurance from AIG.
Why then do people ignore base rates?
This question has been of great interest to psychologists for quite some time and there are a number of theories that revolve around different forms of cognitive bias. Reduced to practical reasons, people ignore base rates due to:
- Availability – the “availability heuristic” or “availability cascade” suggests that decisions are based on what is preoccupying your mind, meaning that while driving to the airport people tend to think about the flight they are about to take and therefore overweight the possibility of a crash, while at the same time ignoring or underweighting that they are much more likely to die in a car accident on the way to the airport.
- Ambiguity – in many cases it is not necessarily ignoring the base rate, rather an acknowledgement that one simply does not know the base rate, the “ambiguity effect”. If a person is unaware that only 1 in 11 million people die as a result of a plane crash, then $50 for $500,000 may seem like a good deal.
- Sense of Control – understandably people want to actively control their risks. There are a number of biases that demonstrate individuals are willing to significantly overpay in order to eliminate a small risk, “zero-risk bias” or to gain perceived control over a possible outcome, the “pseudo-certainty effect”.
Using base rates to your benefit.
Given base rates are often ignored, the same as insurance companies or casinos, you too can profit. You can use base rates to make better decisions, but using a different strategy. Almost every company across a diverse range of industries such as medical, insurance, entertainment and technology use base rates to target millions of consumers who make small, seemingly insignificant decisions. These individual decisions collectively add up to billions in profits, a “nickel and dime” strategy.
Your strategy to profit from base rates must be different, basically the opposite of the “nickel and dime” strategy. Instead of targeting relatively insignificant decisions, you will benefit by looking at those major, tough decisions in life where making a mistake may have significant consequences. You need to factor in base rates when making a major purchase like buying a house or car, when deciding to open a business or pursue a specific degree, or more importantly when determining if a risky medical procedure is your best option.
Using a risky medical procedure, say heart surgery, let's go through a quick example. Thanks to the Internet there is now a wealth of base rate information only a few clicks away. You can find out what are the base rate odds of surviving the heart procedure, but don’t stop there. You can then begin to adjust from this base by factoring in the base rate performance of specific hospitals and/or specific doctors. In addition, you can find out base rates of post surgery rehabilitation and life expectancies. Using this base rate information can help you make a more informed decision, give you a better chance of surviving the procedure and know what to expect after the procedure is over.
In summary, one way to avoid trouble and make better decisions is recognizing that it's all about that base rate. When faced with a tough decision, taking into account the possibility of base rate neglect can improve your chances of success. And if you don’t happen to know Meghan Trainor or the song, then click here to see my shameful attempt at humor.
Richard Feenstra is an educational psychologist who adamantly denies the existence of a video of him singing "All About That Base".