Question: Why is the "inside view" not wise when investing?
The inside view says that when we face a problem, what
all of us typically do is gather lots of information about the problem,
combine it with our own inputs and then we forecast into the future. So
that could be, you know, "How long is it going to take me to remodel my
kitchen? When am I going to finish my term paper? How long will launch a
new product for a company?"
The outside view in contrast says
I’m going to look at my problem as an instance of a larger reference
class. So it allows me to ask a really simple question which is, "When
other people have been in this situation, what happens statistically or
probabilistically?" There are lots of problems that we face as
individuals that are unique to us, but lots of other people have been
through before so there’s this thing called the database of humanity
waiting for you to tap into it.
The inside view, by the way,
importantly, is the natural way to do things; it’s sort of how your
mind’s naturally going to work. So the outside view requires you
basically to leave aside this cherished information that you’ve gathered
and your own point of view on things in order to forecast.
it turns out that we all tend to be too reliant on the inside view which
often leads to too optimistic assessments of our futures. So you know
the old things, people say "How long’s it going to take you to remodel
your kitchen," and people will say to you, "Whatever you think, double
the time and double the cost," right? Because you’re relying on the
inside, they’re telling you, they’re reminding you to go back to the
outside view. But it’s true for the world of investing as well which is
we have lots and lots of data about, for example, the growth rates of
companies or the return on invested capital patterns or the returns of
assets over time and we tend to be caught up very much in the moment
with our own points of view, we tend to leave that kind of information,
valuable information, to the side.
So the point is, when
appropriate, always seek to look for the outside view and help that
inform your inside view and again, more times than not, it tends to damp
optimism that’s unduly generated. Question: How much
should an investor take past performance into account?
: Everybody knows that the outcomes they observe are a
combination of skill and luck, but I think as people, we tend to be not
very good at understanding the relative contributions of the two. So one
of the ways I like to think about this is there are some activities in
life that are pure skill. If you and I have a running race or something
like that, you know, the faster person will win almost every single
time. And there are some activities that are pure luck. If you go
roulette or you roll the dice, it’s going to be randomness and then
almost everything else in life is in between. But what’s interesting is
they're not right in the middle, they’re almost always leaning toward
the skill side or they’re leaning toward the luck side.
question is always when you’re observing a particular activity, where is
it on the continuum? One of the things I like to think about are
sports, because we have a lot of data on sports and people tend to be
very familiar with them. But it probably wouldn’t come as a big surprise
that things like baseball or premier league soccer in the UK tend to be
a lot more on the randomness/luck side and things like basketball or
tennis tend to be much more on the skill side. So it’s an interesting
thing that most of us know that skill and luck combine for outcomes, but
we don’t have a good sense of where things lie.
So that has all
sorts of important implications. I’ll just mention a couple of them.
The first is whenever there’s luck in the system, there’s going to be
lots of reversion to the mean. That means if you have an extreme event,
either extremely good or extremely bad, you should expect the next thing
to be closer to average. So that’s true, for example, for corporate
performance. If a company’s been doing really, really well, sales growth
has been really rapid, you should expect that the next growth rate
should be something closer to average.
The second thing that’s
really interesting is what kind of feedback you give people. Feedback in
our society tends to be very outcome-oriented, based on what we have
observed, and does it really reckon with this issue of the skill/luck
contribution. But if you’re giving feedback properly, it should be
focused only on the skill component, only on what people can control and
to the best of your ability; you should leave aside sort of the
randomness or the luck component.
Recorded on May 14, 2010
Interviewed by Jessica Liebman