Imagine a large taxi company has 20 percent yellow cabs and 80 percent red cabs. That means the base rate for yellow taxi cabs is 20 percent and the base rate for red cabs is 80 percent.
If you order a cab and want to guess its color, remember the base rates and you will make a fairly accurate prediction. But it has been seen that we tend to neglect the base rate.
One of the reasons we find ourselves ignoring the base rate is that we focus on what we expect rather than what is most likely.
For example, imagine those cabs again: If you were to see five red cabs pass by, you’d probably start to feel it’s quite likely that the next one will be yellow for a change.
But no matter how many cabs of either color go by, the probability that the next cab will be red will still be around 80 percent – and if we remember the base rate we should realize this.
But instead we tend to focus on what we expect to see, a yellow cab, and so we will likely be wrong.
And this happens with Equity returns where short term focus drives us away from the base rate.
We miss out on –
1) It’s cyclical but very unpredictable nature.
2) The fact that over the long term it climbs.
If one were to simply to follow this principle, then it would become easy to figure out how one must invest ; i.e to do an SIP over the long term.
But this seldom happens.
Instead of understanding the base rate, we tend to focus on the recent rate.
So if recent returns have been good we start expecting good returns going forward and if recent returns have been bad we expect this trend to continue even though base rate seems to say something different.
Therefore the best steps to investing are:-
1) Recent spate of great returns could mean low returns going forward and vice versa.
2) Since timing the market is virtually impossible just keep investing regularly by following the SIP method
3) Since base rate indicates clearly that in the long term returns move upwards, have the patience to live through the ups and the downs.