Inside View vs. Outside View: A Critical Thinking Framework for Investing

Online Value Investing Workshop – August 2024 Cohort: I recently opened admission to the August 2024 cohort of my Online Value Investing Workshop, which has already been taken by 1800+ students ever since I launched it two years ago. Here is what you get when you sign up for this workshop – 

• 30+ hours of pre-recorded lectures and Q&A videos
• 60+ questions answered in the Q&A
• Live Q&A session of 3 hours on Sunday, 25th August 2024 (7 PM IST Onwards)
• One-year unrestricted access to the entire content
• 7 readymade screens to filter high quality stocks (and avoid the bad ones)
• Bonus 1: Stock analysis spreadsheet (otherwise priced at ₹1999)
• Bonus 2: Rethinking Financial Freedom Masterclass + The Art of Investing Masterclass (otherwise priced at ₹1998)

I am accepting 100 students for this cohort, and more than half the seats have been booked by now. Click here to read the details of the workshop and sign up.

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I’ve been reading Michael Mauboussin’s Think Twice: Harnessing the Power of Counterintuition over the past few days. It’s one of those books that makes you pause every few pages, look up from the text, and mutter, “Oh, I’ve been thinking about this all wrong.”

Among the sea of ideas Mauboussin has covered in his book, one idea that I have been thinking about deeply is the distinction between the “inside view” and the “outside view” in decision-making.

First explained by Daniel Kahneman in his book Thinking Fast and Slow, the ‘inside view vs outside view’ idea looks like a deceptively simple thinking framework on the surface. But the more you think about it, the more you realize how deep and meaningful it is to apply to your investing or any other decisions.

Mauboussin explains in his book –

An inside view considers a problem by focusing on the specific task and by using information that is close at hand, and makes predictions based on that narrow and unique set of inputs. These inputs may include anecdotal evidence and fallacious perceptions. This is the approach that most people use in building models of the future and is indeed common for all forms of planning.

[…]

The outside view asks if there are similar situations that can provide a statistical basis for making a decision. Rather than seeing a problem as unique, the outside view wants to know if others have faced comparable problems and, if so, what happened. The outside view is an unnatural way to think, precisely because it forces people to set aside all the cherished information they have gathered.

When I think about these thoughts, I realize how many times I have fallen into the trap of the inside view, getting so caught up in the specifics of a particular stock or investment opportunity that I lost sight of the outside view.

After all, the inside view is our natural, intuitive approach to problem-solving, and involves –

• Focusing on the specific details of the situation at hand,
• Using readily available information, and
• Constructing scenarios based on our understanding of the case.

When it comes to investing, the inside view often shows up as a detailed analysis of a specific company or asset, which includes poring over financial statements, listening to conference calls, or analyzing industry trends.

Just as an example, let’s consider an investor contemplating an investment in Zomato (no recommendation, pure education).

The inside view might focus on –

• Zomato’s recent turnaround into profitability
• The company’s charismatic leadership
• Its growing market share against Swiggy and other players
• Increasing consumer interest in food delivery services
• Recent run-up in its stock price

Based on these factors – ironically, often the last one – an investor might project rapid growth and market dominance for the company and a further surge in its stock price, leading to a decision to invest in the stock.

The outside view, by contrast, steps back from the specifics of the situation and asks –

• How have similar situations played out in the past?
• What are the base rates or statistical likelihoods for different outcomes?
• How does this situation compare to a broader reference class of similar cases?

Continuing our Zomato example, an outside view might consider –

• Historical performance of food delivery companies across other markets
• Market share evolution in such new-age and evolving industries. Competitive intensity in the food delivery space, with players like Swiggy, Dunzo, and new entrants vying for market share. Intense price wars and aggressive discounting can erode profit margins.
• Base rates for how often companies with Zomato’s valuation multiples deliver solid long-term returns

This perspective might reveal that, for example, successful new entrants and profitability impact in such a rapid growing industry are common, or that companies with extremely high valuations often struggle to meet investor expectations over the long term.

Now, considering the outside view is a sound way of analysing the situation because it helps counteract several cognitive biases that can lead to poor decisions. Biases like –

• Overconfidence: We tend to be too confident in our ability to predict outcomes, especially when we have a lot of information about a specific case.
• Narrative Fallacy: We are prone to constructing compelling stories that explain past events and project them into the future, often ignoring the role of chance.
• Anchoring: We often rely too heavily on one piece of information (stock price surge, recent profits) when making decisions.

When we force ourselves to consider a broader set of outcomes and base rates, the outside view can lead to a more balanced and realistic assessment, which is the hallmark of a sound investing process.

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It’s All About the Balance

While the outside view is a powerful tool, you must not wholly disregard the inside view. Your goal as an investor is to use both perspectives to arrive at a more balanced decision.

Mauboussin suggests adjusting around the ‘base rate’ (a statistic that tells you how common something is generally), which involves –

1. Start with the outside view – What is the base rate for similar situations?
2. Then adjust based on the inside view – What specific factors in this case might lead to a deviation from the base rate?

Continuing with the Zomato example, the outside view can be –

• Stocks trading at high P/E ratios tend to underperform over the long term
• Companies in this industry typically earn X% return on equity as they grow and become more mature

Then, a carefully thought out inside view adjustment (remember to be unbiased) could be –

• This company has a good management team with a strong track record
• Recent investments in technology could improve margins and lead over competitors
• A new product line is showing promise

The final decision would ultimately weigh both the generally unfavourable odds for expensive stocks (outside view) and the specific factors that might make this company outperform its peers (inside view).

Powerful Tool, But…

All in all, I believe the inside view vs. outside view framework from Kahneman and Mauboussin is a powerful tool you can use to improve your investment decision-making.

When you consciously separate these two perspectives and use techniques like base rates, you can hope to make a more balanced and realistic assessment of the investment opportunities in front of you.

However, it’s important to remember that this framework, like any tool, has its limitations. Markets are complex adaptive systems, and past patterns do not always predict future outcomes.

Your main goal as an investor is not to ignore your specific knowledge or insights about an investment (and also what your gut is telling you after all the analyses), but to contextualize them within a broader thinking framework.

That is what makes you an intelligent investor.

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Stock Analysis Made Easy

Before I end, check out my comprehensive automated stock analysis spreadsheet, which can help you perform a comprehensive (inside view) financial and business analysis of listed Indian companies.

Here are some key things this automated stock analysis spreadsheet can help you with –

• Pre-Built Analysis Models: So you don’t have to waste hours entering data and maintaining your spreadsheets. The automated spreadsheet does it all and lets you customize it.
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• Key Metrics: Easily check key metrics like ROE, ROCE, Gross Margin, Debt to Equity, Free Cash Flow, etc. to determine the quality of the business.
• Explanations: Explanations of key terms and ratios to help you understand nuances of financial statement analysis.

How to Get this Spreadsheet?

Multiple ways –

1. Click here to pay a small fee to get the spreadsheet on a standalone basis.
2. You can get it for FREE by joining Mastermind – my most comprehensive value investing course and membership.
3. You can get it for FREE by joining the August 2024 cohort of my online value investing workshop.

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That’s all from me for today.

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Thank you for your time and attention.

~ Vishal

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P.S. Additional Reading

• Think Twice – Michael Mauboussin
• Thinking Fast and Slow – Daniel Kahneman