You are reading the 2026 curriculum (exams up to November 2026). Sitting in February 2027 or later? Go to the 2027 Quantitative Methods guide.
Bayes' formula: updating a probability with new information
Bayes' formula turns a prior probability into a posterior: P(Event | Info) = P(Info | Event) × P(Event) ÷ P(Info). The denominator, P(Info), is the total chance of seeing that information across every scenario. The update is large when the information is much likelier under one scenario than the others.
Before this: Probability trees and conditional expected values
On the exam
- Calculate and interpret an updated probability in an investment setting using Bayes’ formula
Calculate and interpret an updated probability using Bayes' formula. Expect the joint probability or the likelihood to be offered as answer options, and sometimes three scenarios instead of two.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
What are the parts of Bayes’ formula?
News arrives and you want to revise a probability. Start with the prior probability , your view of the event before the news. The likelihood is how probable the news is if the event is true. After the update you hold the posterior probability , the probability of the event given the news.
- Prior P(E) Memorize your probability before the news
- Likelihood P(I | E) Memorize how likely the news is if the event is true
- P(I) Memorize total chance of the news: add every branch that produces it
- Event branch P(I | E) × P(E)
- No-event branch P(I | not E) × P(not E)
-
- Posterior P(E | I) Memorize event branch ÷ P(I)
Bayes’ formula connects them. The denominator, P(I), is the unconditional probability of the information.
P(I) comes from the total probability rule : add up every route that can produce the information.
The top of Bayes’ formula, P(I | E) × P(E), is the joint probability of the event and the information. So the posterior is the joint probability divided by the total probability of the information: your share of all the ways the news could have happened.
An analyst puts a prior probability of 40.00% on an event. The news arrives 75.00% of the time when the event occurs and 15.00% of the time when it does not. After the news, the probability of the event is closest to:
0.75 × 0.4 ÷ (0.75 × 0.4 + 0.15 × 0.6) = 0.769231, so 76.92%
Posterior probability, P(E | I)76.92%
- 0.4×0.75=STO1the joint probability
- +(0.6×0.15)=P(information)
- 1/x×RCL1=the posterior
STO store · 1/x reciprocal · RCL recall a stored number
- 0.4ENTER0.75×STO1the joint probability
- 0.6ENTER0.15×+P(information)
- 1/xRCL1×the posterior
ENTER enter (on the HP, puts the number on the stack) · STO store · 1/x reciprocal · RCL recall a stored number
Try this 0 of 3
- Cut the prior to 0.10 with the same news
- Make the news worthless: set both likelihoods equal
- Switch the news to 'Does not raise'
Before the news a beat is 0.40 likely. Guidance is raised with probability 0.390 in all; 0.300 of that comes from firms that beat, so the posterior is 0.769.
- Before the news, P = 1.00
- p = 0.40: Beats consensus, prior 0.40
- p = 0.75: Raises guidance, joint 0.300, fits the news: beat, (matches), (highlighted)
- p = 0.25: No raise, joint 0.100, ruled out, (ruled out)
- p = 0.60: Does not beat, prior 0.60
- p = 0.15: Raises guidance, joint 0.090, fits the news: no beat, (highlighted)
- p = 0.85: No raise, joint 0.510, ruled out, (ruled out)
- p = 0.40: Beats consensus, prior 0.40
Show working
Prior P(beat) = 0.40; likelihoods P(raise | beat) = 0.75, P(raise | no beat) = 0.15
P(raise) = 0.75 × 0.40 + 0.15 × 0.60 = 0.3000 + 0.0900 = 0.3900
P(beat | raise) = P(raise | beat) × P(beat) ÷ P(raise) = 0.3000 ÷ 0.3900 = 0.7692
The news moves the probability of a beat from 40% to 76.9%. Not 0.75 (the likelihood) and not 0.300 (the joint probability).
- 0.75×0.4=STO1joint 0.3000
- 0.15×0.6=+RCL1=STO2P(raise) = 0.3900
- RCL1÷RCL2=posterior 0.7692
STO store · RCL recall a stored number
- 0.75ENTER0.4×STO1joint 0.3000
- 0.15ENTER0.6×+P(raise) = 0.3900
- RCL1x≷y÷posterior 0.7692
ENTER enter (on the HP, puts the number on the stack) · STO store · RCL recall a stored number · x≷y swap the last two numbers
Display: 0.7692
Slide the prior down and the two likelihoods together. The posterior moves much less when the prior is low, and much more when the two likelihoods are far apart.
A table method that never fails
Lay out every joint probability in a grid and read the posterior from a column. For the example above:
| Raises guidance | Does not raise | Row total | |
|---|---|---|---|
| Beats consensus | 0.30 | 0.10 | 0.40 |
| Does not beat | 0.09 | 0.51 | 0.60 |
| Column total | 0.39 | 0.61 | 1.00 |
Each cell is a prior times a likelihood. The posterior is the cell divided by its column total once you know which news you saw: given a raise, 0.30 ÷ 0.39 = 0.769. Had the company not raised, it would be 0.10 ÷ 0.61 = 0.164.
The same method works with more than two scenarios. Add a row for each.
What is a diffuse prior?
Diffuse prior is the name for equal priors: you have no basis to favor any scenario, so each gets the same probability. Then the priors cancel from the top and bottom of the formula, and the posterior follows the likelihoods alone. Each posterior is then its likelihood divided by the sum of the likelihoods. With two scenarios and likelihoods of 0.6 and 0.2, equal priors of 0.5 give posteriors of 0.6 ÷ 0.8 = 0.75 and 0.2 ÷ 0.8 = 0.25.
Exam tip When the question gives you P(I | E) but you need P(E | I), write the table first. If the column total is missing, the question wants the total probability rule.
Go deeper Base-rate neglect: why a rare event stays unlikely
Suppose 1% of firms will default in a year, a screen flags 90% of firms that will default and also flags 9% of firms that will not. A flagged firm looks alarming, yet P(flag) = 0.9 × 0.01 + 0.09 × 0.99 = 0.0981, so the posterior is 0.009 ÷ 0.0981 = 9.2%. The low prior limits the update. Ignoring the prior and treating the 90% likelihood as the answer is a classic behavioral error.
Go deeper Sequential updating
Yesterday’s posterior becomes today’s prior. After the guidance raise the probability of a beat is 0.769. If a second signal, an analyst upgrade, then arrives, appearing for 60% of beaters and 20% of non-beaters, and the two signals are independent given the outcome, then P(upgrade) = 0.6 × 0.769 + 0.2 × 0.231 = 0.508 and the new posterior is 0.462 ÷ 0.508 = 0.909.
Memorize this
MemorizeBayes' update
| Piece | Symbol | Meaning |
|---|---|---|
| Prior | P(E) | before the news |
| Likelihood | P(I | E) | news if the event is true |
| Joint | P(I | E) × P(E) | news and event |
| Information | P(I) | sum of every joint for the news |
| Posterior | P(E | I) | joint ÷ P(I) |
Memory hook The posterior is your share of all the ways the news could have happened: the event branch over every branch with the news.
Know it cold Posterior = likelihood × prior ÷ P(I). Posteriors over all scenarios add to 1.
MemorizeDiffuse prior
Memory hook No reason to favor any scenario, so give each the same prior. The priors then cancel and the likelihoods alone set the posterior.
Know it cold Equal priors: posterior = likelihood ÷ sum of the likelihoods.
- Prior P(E) Memorize your probability before the news
- Likelihood P(I | E) Memorize how likely the news is if the event is true
- P(I) Memorize total chance of the news: add every branch that produces it
- Event branch P(I | E) × P(E)
- No-event branch P(I | not E) × P(not E)
-
- Posterior P(E | I) Memorize event branch ÷ P(I)
Quick example
P(E) = 0.20, P(I | E) = 0.90, P(I) = 0.30. P(E | I) = 0.90 × 0.20 ÷ 0.30 = 0.60.
- 0.9×0.2=÷0.3= 0.6
- 0.9ENTER0.2×0.3÷ 0.6
ENTER enter (on the HP, puts the number on the stack)
Quick example
P(E) = 0.20, P(I | E) = 0.90, P(I | not E) = 0.10. P(I) = 0.18 + 0.08 = 0.26.
- 0.2×0.9+(0.8×0.1)= 0.26
- 0.2ENTER0.9×0.8ENTER0.1×+ 0.26
ENTER enter (on the HP, puts the number on the stack)
Quick example
Priors 0.6, 0.3, 0.1 and likelihoods 0.2, 0.5, 0.9. P(I) = 0.12 + 0.15 + 0.09 = 0.36. Posterior of the first: 0.12 ÷ 0.36 = 0.333.
- 0.6×0.2=STO1
- +(0.3×0.5)+(0.1×0.9)= 0.36
- 1/x×RCL1= 0.3333
STO store · 1/x reciprocal · RCL recall a stored number
- 0.6ENTER0.2×STO1
- 0.3ENTER0.5×+0.1ENTER0.9×+ 0.36
- 1/xRCL1× 0.3333
ENTER enter (on the HP, puts the number on the stack) · STO store · 1/x reciprocal · RCL recall a stored number
How it is asked
-
Two-state posterior
Prior 0.10; news 80% likely if the event is true, 10% likely otherwise. Posterior?
P(I) = 0.08 + 0.09 = 0.17; 0.08 ÷ 0.17 = 0.47. Traps: 0.08 (joint), 0.80 (likelihood).
-
Find P(information) only
Same facts. Unconditional probability of the news?
Add both branches: 0.8 × 0.1 + 0.1 × 0.9 = 0.17. Trap: 0.08 (event branch only).
-
Three scenarios
Priors 0.6, 0.3, 0.1; likelihoods 0.2, 0.5, 0.9. Posterior of the third?
P(I) = 0.12 + 0.15 + 0.09 = 0.36; 0.09 ÷ 0.36 = 0.25.
-
Diffuse prior
Equal priors; likelihoods 0.6 and 0.2. Posterior of the first?
0.6 ÷ (0.6 + 0.2) = 0.75.
Exam traps
- Reporting the likelihood P(Info | Event) as if it were the posterior.
- Reporting the joint probability P(Info and Event) without dividing by P(Info).
- Computing P(Info) from the event branch only. Add every scenario that can produce the information.
- Leaving out the prior: a strong signal about a rare event does not make it likely.
Checkpoint
5 exam-style questions. About 90 seconds each.
1An analyst puts a 10% prior probability on a bond being downgraded. Bonds that are later downgraded are placed on credit watch 80% of the time, and other bonds 10% of the time. The bond is placed on credit watch. The updated probability of a downgrade is closest to:
2In the same setting, the unconditional probability that a bond is put on credit watch is closest to:
3In Bayes' formula, the probability of the new information given that the event is true is called the:
4A lender sorts its borrowers into prime (prior probability 0.6), standard (0.3) and subprime (0.1). An early-warning flag is raised for prime borrowers 20% of the time, standard borrowers 50% of the time and subprime borrowers 90% of the time. A borrower is flagged. The probability that the borrower is subprime is closest to:
5An analyst has no basis to favor either of two scenarios and assigns each a prior of 0.5. A signal appears 60% of the time in the first scenario and 20% of the time in the second. The signal appears. The probability of the first scenario is closest to:
Key takeaways
- Posterior = likelihood × prior ÷ P(information).
- P(information) adds up every branch that produces it, by the total probability rule.
- Strong news moves a probability a lot; a low prior limits how far.
- With a diffuse (equal) prior, the likelihoods alone decide the posterior.
Quick example
P(E) = 0.20, P(I | E) = 0.90, P(I) = 0.30. P(E | I) = 0.90 × 0.20 ÷ 0.30 = 0.60.
- 0.9×0.2=÷0.3= 0.6
- 0.9ENTER0.2×0.3÷ 0.6
ENTER enter (on the HP, puts the number on the stack)
Quick example
P(E) = 0.20, P(I | E) = 0.90, P(I | not E) = 0.10. P(I) = 0.18 + 0.08 = 0.26.
- 0.2×0.9+(0.8×0.1)= 0.26
- 0.2ENTER0.9×0.8ENTER0.1×+ 0.26
ENTER enter (on the HP, puts the number on the stack)
Quick example
Priors 0.6, 0.3, 0.1 and likelihoods 0.2, 0.5, 0.9. P(I) = 0.12 + 0.15 + 0.09 = 0.36. Posterior of the first: 0.12 ÷ 0.36 = 0.333.
- 0.6×0.2=STO1
- +(0.3×0.5)+(0.1×0.9)= 0.36
- 1/x×RCL1= 0.3333
STO store · 1/x reciprocal · RCL recall a stored number
- 0.6ENTER0.2×STO1
- 0.3ENTER0.5×+0.1ENTER0.9×+ 0.36
- 1/xRCL1× 0.3333
ENTER enter (on the HP, puts the number on the stack) · STO store · 1/x reciprocal · RCL recall a stored number
Questions about this lesson?
Where this comes back
- The Behavioral Biases of Individuals Portfolio Construction
- Credit Risk Fixed Income
Questions candidates ask
How do you use Bayes' formula in CFA Level 1?
Find the prior and the likelihood of the information under each scenario. Multiply each prior by its likelihood to get the joint probabilities, add them to get P(information), then divide the joint probability of your scenario by P(information). That ratio is the posterior.
What is the difference between prior and posterior probability?
The prior is your probability for an event before new information arrives. The posterior is the revised probability after you have taken the information into account. Today's posterior can become tomorrow's prior when the next piece of news arrives.
What is a diffuse prior?
A diffuse prior gives every scenario the same probability because you have no reason to favor one. The priors then cancel in Bayes' formula, so the updated probabilities depend on the likelihoods alone.
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