The Concept of Base Rates

I recently came across an interesting concept called the “outside view” while watching a lecture by Michael Mauboussin, a finance professor at Columbia Business School. He talked about the idea of base rates, which is particularly relevant in the context of financial investments.

When researching a company, many smart people try to create their own model. For example, they might look at a company like Adidas and develop a discounted cash flow model. Based on their analysis, they might predict that the company’s market cap will double in 3-5 years.

However, this approach is very much an “inside view” - it relies heavily on our own perspective and assumptions.

The Outside View: A Better Approach

Mauboussin suggests that we can do better by looking at the outside view - the base rates. Instead of creating your own model, you can look at companies similar to Adidas, like Nike, Under Armour and Puma. You can examine their historical progression on average:

  • How long did it take these similar companies to double its market cap from $20 billion to $40 billion?

  • What was their growth trajectory?

Using this the base rates, you can make a more informed prediction about Adidas’s potential growth. If it took these companies 6-8 years to double its market cap, you might hypothesize that it could take Adidas a similar amount of time.

The Importance of Humility

This concept is crucial because we humans tend to be self-centered and often overrate our abilities. We believe in our individuality and think we’re special. But the truth is, having a bit of humility can lead to better problem-solving and research.

The best way to approach many situations is to look at the outside view - the base rates. This requires us to set aside our ego and acknowledge that we might not have all the answers.

A Real-World Example

I recently interviewed with a software company with a brilliant founder who, without explicitly knowing about base rates or the outside view, demonstrated this concept in practice.

This founder had developed a successful product in the AI fantasy chat app that grew exponentially in millions of revenue within 9 months. What fascinated me was how he arrived at this idea.

Instead of relying solely on his own take or intuition of what to build or whatever, he conducted market research. He looked at the top AI apps by user base and found that after ChatGPT, the second most popular app was Character.ai - a fantasy chat app where users can talk to fictional characters.

When Character.ai was bought by Google and stripped of some features, this founder identified a gap in the market. He capitalized on this opportunity by building a product to fill that gap, which became very successful.

The Value of the Outside View in Product Development

What makes this founder brilliant, in my opinion, is his ability to apply the outside view when developing a product idea. Instead of relying only on his own perspective or a handful of personal experiences, he studied existing successful products and identified proven market demands.

What amazes me most is that he developed this mindset intuitively, at such a young age. Even though he may not be explicitly aware of this concept of base rates, he has arrived at it through instinct and observation.

Perhaps his background in science and mathematics has something to do with it. A training that emphasizes data, probabilities, and base rates naturally brings a sense of humility and a statistical way of thinking. In contrast, I have noticed that people with backgrounds like law often lean heavily on the inside view, relying on confidence in their own reasoning (arrogance?), assumptions, and personal perspective before eventually being forced to confront the outside reality.

This outside-in approach stands in sharp contrast to how many of us (myself included) often approach product development. Typically, it looks something like this:

Identify a personal need (e.g., a tool for stock investing).

Assume there is a broader demand based on limited evidence (such as a few conversations with people who share the same problem).

Build a product and try to sell it.

While this method can sometimes succeed, it often relies too heavily on subjective assumptions. Without grounding our ideas in actual market evidence, we risk building products that solve problems only for ourselves and a handful of others.

The outside view, by comparison, forces us to ask: What has worked before? What do the base rates suggest? Where is demand already proven?

By starting there, we significantly improve our odds of building something that not only excites us but also resonates with the market.

The Increasing Importance of the Outside View

As AI continues to advance, making various types of work (art, coding, writing, etc.) cheaper and more accessible, the importance of choosing the right work to focus on will only increase. We have limited time and focus, so it’s crucial to direct our efforts towards the most promising opportunities.

This is where the concept of the outside view becomes even more valuable. By looking at base rates and existing successful models, we can make more informed decisions about where to invest our time and energy.

Conclusion

The outside view is an underrated concept that should be implemented more in our decision-making processes. It allows us to judge ideas and decisions based on a larger pool of data, rather than relying solely on our own opinions or limited experiences.

As work becomes increasingly commoditized, our ability to choose the right focus will become our most valuable skill. The outside view gives us a powerful tool to make these crucial decisions more effectively.