Greenbackd

Michael Mauboussin appeared Friday on Consuelo Mack’s WealthTrack to discuss several of the ideas in his excellent book, Think Twice. Particularly compelling is his story about Triple Crown prospect Big Brown and the advantage of the “outside view” – the statistical one – over the “inside view” – the specific, anecdotal one (excerpted from the book):

June 7, 2008 was a steamy day in New York, but that didn’t stop fans from stuffing the seats at Belmont Park to see Big Brown’s bid for horseracing’s pinnacle, the Triple Crown. The undefeated colt had been impressive. He won the first leg of the Triple Crown, the Kentucky Derby, by 4 ¾ lengths and cruised to a 5 ¼-length win in the second leg, the Preakness.

Oozing with confidence, Big Brown’s trainer, Rick Dutrow, suggested that it was a “foregone conclusion” that his horse would take the prize. Dutrow was emboldened by the horse’s performance, demeanor, and even the good “karma” in the barn. Despite the fact that no horse had won the Triple Crown in over 30 years, the handicappers shared Dutrow’s enthusiasm, putting 3-to-10 odds—almost a 77 percent probability—on his winning.

The fans came out to see Big Brown make history. And make history he did—it just wasn’t what everyone expected. Big Brown was the first Triple Crown contender to finish dead last.

The story of Big Brown is a good example of a common mistake in decision making: psychologists call it using the “inside” instead of the “outside” view.

The inside view considers a problem by focusing on the specific task and by using information that is close at hand. It’s the natural way our minds work. The outside view, by contrast, asks if there are similar situations that can provide a statistical basis for making a decision. The outside view wants to know if others have faced comparable problems, and if so, what happened. It’s an unnatural way to think because it forces people to set aside the information they have gathered.

Dutrow and others were bullish on Big Brown given what they had seen. But the outside view demands to know what happened to horses that had been in Big Brown’s position previously. It turns out that 11 of the 29 had succeeded in their Triple Crown bid in the prior 130 years, about a 40 percent success rate. But scratching the surface of the data revealed an important dichotomy. Before 1950, 8 of the 9 horses that had tried to win the Triple Crown did so. But since 1950, only 3 of 20 succeeded, a measly 15 percent success rate. Further, when compared to the other six recent Triple Crown aspirants, Big Brown was by far the slowest. A careful review of the outside view suggested that Big Brown’s odds were a lot longer than what the tote board suggested. A favorite to win the race? Yes. A better than three-in-four chance? Bad bet.

Mauboussin on WealthTrack:

Hat Tip Abnormal Returns.