Base rates and the right side of history, Part 2 – with Dan Rasmussen
What makes investing so much fun, says our latest podcast guest, is trying to apply both history and statistics to make good decisions about the future – while ideally knowing as much as you can about the past
In The right side of history – Part 1, deep-value investor, author and recent guest on The Value Perspective podcast Dan Rasmussen argues that focusing on ‘base rates’ – that is, giving greater weight to more general probabilities than to newer or more immediate information – is the best way to learn the lessons of history. How then does he incorporate base rates into his own analysis and investment process?
“I find myself constantly evolving on that question but let’s try to answer it by thinking about equities,” he begins. “First-order base rate analysis simply holds that you start with a cross-section of stocks. So, every year, you take every stock in the market and then you analyse the distribution of outcomes for owning any random stock. That is your most basic base rate.
“You could say, for example, there is a roughly 30% outcome I make a lot of money; a roughly 30% outcome I make something around zero to 5%; and a roughly 30% outcome, I lose a lot of money – and then, over time, the way that ends up working is I make money. This way, when you buy a stock, you understand your base-rate probability of outcome.
“Second-order base rate analysis then tells you base rates are conditional – that there are factors that meaningfully affect the probable distribution of outcomes. I think about these as factors that are going to show up as highly statistically significant in a regression – so, for example, you will see different outcomes from a sample of small stocks versus a sample of large stocks. Or from value versus growth.
“In the same way, companies with negative free cashflow or negative net income have highly different outcomes to companies with positive free cashflow or positive net income, right? So you can look through the scope of history and condition your probabilities on important knowable conditions that do meaningfully change the probable distribution of outcomes. That is the next line of analysis.”
The question Rasmussen has been working on himself for the last few years is the extent to which economic conditions change those base rates. “Say I am in the middle of a recession, does that meaningfully change the conditional probabilities I am assigning to different outcomes for stocks?” he asks. “For me, the answer is it does make a big difference. And it also makes a big difference if there is a massive inflationary spike.
“So you can start layering all of these different considerations into your conditional probability distribution to come up with a view of what the appropriate base rates are. And, of course, that is a process that requires human judgement because you have to think about the probable conditions you are applying to this. Are they reasonable? What historical analogies might be useful to consider?”
Problems can arise, however, Rasmussen argues, when investors who are not trained to think and analyse businesses in this way use their own lived experience as their primary source of base rates. “This is why you see people decide to put all their money in growth stocks and bitcoin – because they started investing in 2010 and that has been the best outcome,” he adds.
“From watching that personal base rate, they ‘know’ value doesn’t work and they ‘know’ cryptocurrencies do – and therefore they take a particular course of action. What they have got wrong, though, is their base rate is a very narrow sliver of the potential distribution of probabilities. In contrast, what a lot of us are trying to do is expand the scope of historical analogues to say, well, couldn’t what happened in Japan happen in the US?
“All these different economic conditions have happened so could the 1960s, say, happen again? Could the 1930s? Hopefully not but we should probably think about that – and this is where the art of the historian and the statistician intersect. It is also what makes investing so much fun. You are trying to apply both history and statistics to make good decisions about the future – ideally knowing as much as you can about the past.”
Associate Investment Director, Equity Value
I joined Schroders in 2016 after spending 3 years as an analyst at the Royal Bank of Scotland. I them moved in to the Value team in January 2018 as an investment specialist after working for two years in Schroders' Distribution division. I am a CFA Charterholder and hold an MSc in Corporate Strategy from The University of Nottingham.
Juan Torres Rodriguez
Fund Manager, Equity Value
I joined Schroders in January 2017 as a member of the Global Value Investment team and manage Emerging Market Value. Prior to joining Schroders I worked for the Global Emerging Markets value and income funds at Pictet Asset Management with responsibility over different sectors, among those Consumer, Telecoms and Utilities. Before joining Pictet, I was a member of the Customs Solution Group at HOLT Credit Suisse.
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