April 13, 2010
Those who bet on Big Brown were taking the inside view, expecting success based on his performance in his prior two races. According to Mauboussin, when taking the inside view, one focuses on the specific problem at hand, making predictions based on that narrow and unique set of inputs.
A careful analysis, though, would have revealed important clues that Big Brown should not have been as heavily favored as he was. One taking the outside view would have asked how other horses did in similar situations.
In the last 130 years, approximately 40% of potential Triple Crown winners succeeded in winning the Belmont, but since 1950 only three of 40 have succeeded – a 15% success rate, far below the 77% probability implied by those wagering on Big Brown. Moreover, none have succeeded since 1978.
Perhaps Big Brown was a truly exceptional horse, though, like the Jamaican runner Usain Bolt who demolished sprinting records at the 2008 Olympics. Racing handicappers have a way to assess that – the Beyer Speed Figure, which computes a horse’s speed after adjusting for track conditions, weather, time of day, and other factors.
Big Brown’s Beyer Speeds were the worst of the last seven Triple Crown contenders.
Taking the outside view – a dispassionate and objective analysis – might have steered bettors away from a costly mistake in the 2008 Belmont Stakes.
It’s easy to see the analogy with the discipline of investing. Stock prices are based on expectations, like those reflected by a horse racing parimutuel system. Understanding equity valuations, though, requires a far more nuanced analysis, based on competitive positioning, management skills, strategy, and industry trends. That analysis can only be effectively performed by taking the outside view.
“What you are really looking for is mis-pricings – differences between the tote board and the underlying valuations,” Mauboussin said.
Our natural tendency to take the inside view stems from a number of well-documented biases, according to Mauboussin. A superiority bias causes us to have undue confidence in many skill sets (e.g., 80% of people believe they are better-than-average drivers) and an optimism bias causes us to over-weight the likelihood of positive outcomes (e.g., most people believe they will have better-than-average relationships and career earnings).
The mistake of taking the inside view is often amplified by a false sense of control. A morbid example of that behavior occurred following September 11, when many chose to drive rather than fly, because they believed they were in control of their fate. It was later found that 50% more people died in automobile accidents because of increased auto travel after the terrorist attacks than died as a direct result of September 11.
Why is it so hard for us to take the outside view? “We are profoundly human, and gravitate toward stories,” Mauboussin said. He cited an experiment in which people were presented with various treatments for a hypothetical disease. The researchers found the participants chose less effective treatments when presented with unpleasant (but statistically insignificant) anecdotes regarding the more effective treatment.
Stories and anecdotes conflict with objective analysis, and cause us to take the inside view.
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