An Inside Look at the Outside View
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Generally, people are overconfident when they make forecasts and inexperienced analysts may use less outside data and be less skeptical than they should be.  With an "outside view", analysts incorporate outside data sets to build a better lens for analyzing companies.
In our latest podcast, Director of Market Strategy Brad Neuman discusses his latest white paper, Looking Outside for Better Decisions​.

ALEX BERNSTEIN: Hi. I’m Alex Bernstein and you’re listening to The Alger Podcast.  In his latest white paper, “Looking Outside for Better Decisions,” Alger Senior Vice President and Director of Market Strategy, Brad Neuman, argues that by bringing an “outside view” to one’s investment decisions, an investor can potentially glean insight into problems and pitfalls that may have been unknowable with only an “inside view.”
​To discuss this idea in detail, Brad joins me today.  Brad, thanks so much for taking the time to speak with us.  
BRAD NEUMAN: Thanks Alex.

ALEX: So, what exactly is the “outside view”?

BRAD: Well, there’s two ways to think about a problem or project that you have.  One is the inside view, which is when you think about your own experience or talk with your actual team members about the project that you're going to embark on.  The outside view is – instead of looking at your specific circumstances – you look at other people’s experiences.  

So, in the case of building a house, the inside view would be where you talk to your contractor, and together you come up with a detailed estimate relative to your own experience.  

The outside view would be ignoring what the contractor says initially and going and getting data about how much it costs or how long it takes to build a house, per square foot, in your area or neighborhood.  And that would then become the baseline that you then adjust from.  Maybe the contractor’s very good, and he’s going to get it done quicker than that base rate, baseline estimate, or maybe your land is more rocky than usual and it’s going to take longer.  But the main point is that you're starting the estimate first from other people’s experiences and data outside of your own.  
ALEX: And this leads to what you then call “The Planning Fallacy"?
BRAD: The Planning Fallacy is the fact that people are generally overconfident when they make forecasts. The Planning Fallacy comes from people taking the inside view, and that causes them ultimately to be overly optimistic.  So most people when they embark on projects have too rosy a view of how long it will take or how good it will go.  

If you’re looking to get to the airport in a certain period of time, you go through the estimate of how long it will take you to get downstairs, get the cab.  But there’s always unforeseen things that you wouldn’t factor into that.  If you were to ask other people how long it takes to get to the airport that would be using the outside view, because it would incorporate those unpredictable types of events.  
ALEX: You have a good example of this in the white paper.  Tell me about the Danny Kahneman project.

BRAD: So Danny Kahneman, who won a Nobel Prize for his work in behavioral finance, has this story that illustrates when he fell prey to having an inside view.  Basically, he was tasked with developing a curriculum and writing a book for a high school class dealing with, of all things, behavioral finance.  And he had a very strong team of other teachers and a dean.  And he decided to ask them how long they thought it would take them to finish the book.  And the answers ranged from a year and a half to two and a half years.  

But then he asked the dean if he could think about his experience with other teams that have embarked on similar kinds of projects.  How long did it take them to finish it?  And the dean responded that actually 40 percent of those teams failed to complete the task, and those that did finish took an additional seven to ten years.  Now Kahneman admits that they should have quit right after this revelation, because none of them wanted to invest six more years in a project with a 40 percent chance of failure.  But they still persisted, and lo and behold it took eight more years to finish the book.  
ALEX: You point out that, on a day-to-day level, people typically forecast incorrectly all the time, because they’re not bringing in enough information. 

BRAD: Yes, most people’s reference is their own lives and what they’ve experienced.  The outside view uses the term called “the reference class,” which is a group of data that is similar to the project that you’re embarking on that you should seek out to analyze what other people’s experience has been with the same project. 
ALEX: In the white paper, you illustrate this using Steph Curry, the phenomenal shooting guard for the Golden State Warriors.  How do the Outside View and the reference class apply here? 

BRAD: So there are three steps when you’re using the outside view that you have to go through.  Number one, you have to identify a comparable reference class.  Number two, you have to aggregate the data of the reference class to determine a baseline estimate.  And thirdly, you have to adjust the baseline estimate that we just got in step two by the specific circumstances.  In the paper we say that if Steph Curry, the stunningly successful guard for the Golden State Warriors were flipping a coin, and had gotten 57 percent heads over the past 20 flips, you would still say his next flip should be 50 percent, because you know to adjust all the way back to the baseline.  And the baseline is obviously 50 percent.  

However, if he was shooting free throws, and the baseline estimate is say in the mid-70 percent range, because that’s what NBA shooters generally shoot from the free throw line, you would adjust his probability of making a shot up significantly.  Why?  Because he’s a phenomenal 90 percent free throw shooter over his career, and so you would want to adjust up significantly from that reference class baseline estimate of the mid-70s. 

ALEX: So, how does the outside view apply to the world of investing? 

BRAD: In investing, the reference class could be returns of an asset class.  A lot of people think returns in the stock market will be based on the current situation.  The Outside View is what have been the returns of that asset class from a similar point, or some other starting point?  What have returns been when the Fed is raising rates?  Something like that would be starting with data and the outside view. 

ALEX: Is the outside view just a synonym for research?   
BRAD: The outside view does need research, but it’s more of a change in mindset.  You can do a lot of research for example on your local NFL football team, in terms of how successful each player’s been in the past, and how good the other teams are.  But the outside view forces you to start with the basic fact that in any given year, any given team has about three percent chance of winning the Super Bowl.  Of course, from there, you should make adjustments based on how good you think those teams are.  But it forces you to level set.  

ALEX: But there’s more to it than just corporate fundamentals?

BRAD: Right.  So when you’re researching a stock, if you were going to take the inside view, you would probably listen to management, look at the financials, even come up with a detailed model.  But it would be mostly based on news from that company, what that company is telling you, those kinds of things.  The outside view would be kind of making analogies to other companies in similar situations or other industries going through similar types of dynamics.  And looking at the data to see how that played out.  
ALEX: Isn’t this something that analysts and portfolio managers typically do?

BRAD: Good analysts know that investing is a lot like making analogies.  But you’ll typically find less experienced analysts being less skeptical and using less outside data.

One of the good things about Alger is that Alger’s been investing in growth and innovation for over 50 years.  So at Alger we have a rich experience in data sets that give us a good lens to analyze companies.  And Alger analysts know how to pick winners and losers from change because they’ve studied how change unfolds over time, and in different industries.  That’s using the outside view to help drive excess returns. 

ALEX: Brad, thanks so much for speaking with us today.  

BRAD: Thank you.
ALEX: And thank you for listening.  For more information and to download your own copy of the whitepaper “Looking Outside for Better Decisions” please visit Alger.com.  



​​The views expressed are the views of Fred Alger Management, Inc. as of March 2019. These views are subject to change at any time and they do not guarantee the future performance of the markets, any security or any funds managed by Fred Alger Management, Inc. These views are not meant to provide investment advice and should not be considered a recommendation to purchase or sell securities. Past performance is no guarantee of future results.
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