Most economic theories make an assumption that humans are rational, but this definition is a peculiarly drawn one as it assumes that we all operate on the basis of Bayes’ Theorem, an idea which is freely bandied about but which very few people can actually describe. There’s a good reason for this – it’s profoundly unintuitive, which makes you wonder if we do think the way the theorem suggests we ought to.
Unintuitive or not every investor should have a working appreciation of the ideas behind Bayesian reasoning, because it’s another one of those mental models we can use to assess the usefulness, or otherwise, of our ideas. And oddly enough, it may be even more fundamental than we think.
The original paper on Bayes Theorem was entitled An Essay towards Solving a Problem in the Doctrine of Chances and dates from 1763. It wasn't even published by the eponymous Reverend Baynes but by his friend Richard Price, who discovered it in his papers after his death. As we’d expect under Stigler's Law of Eponymy it’s quite likely that Bayes didn’t even originate Bayes’ Theorem:
“It seems to be a law of the sociology of science that no discovery or invention is named after its first discoverer”.
Anyway, this Bayes Theorem thing seems to be quite important because it keeps popping up in all sorts of different places. The question is, what is it? Well, here it is in the words of the late and possibly great Reverend Bayes’ friend:
“To find out a method by which we might judge concerning the probability that an event has to happen, in given circumstances, upon supposition that we know nothing concerning if but that, under the same circumstances, it has happened a certain number of times and failed a certain other number of times. He adds, that he soon perceived that it be very difficult to do this, provided some rule could be found according for which we ought to eliminate the chance that the probability for the happening of an event perfectly unknown, should lie between any two named degrees of probability, antecedently to any experiment made about it; and that it appeared to him that the rule must be to suppose the chance the same that it should lie between any two equidifferent degrees; which, if it were allowed, all the rest might be easily calculated…