Process vs Outcome: Consider Base Rates & Alternative Histories

What if Germany and the Axis powers had won World War 2? It is a provocative question, one that has become the subject of a lot of theories over the years, even spawning a whole genre of alternative fiction. Yet it is not as far fetched as it might seem, with Germany enjoying early successes before a combination of Hitler’s bizarre decision making, the drawn out Operation Barbarossa invasion of Russia and Japan drawing America into the war after Pearl Harbour.

While an extended discussion of these ideas would no doubt take a whole essay, the point is that the outcomes of history are not as set in stone as they might seem. The world is inherently probabilistic in nature. With different parameters of each variable, the number of possible histories and futures is inherently infinite. This is the core idea behind the many worlds interpretation of quantum mechanics.

This idea challenges our inherent bias towards judging decision making by outcomes. The fact that a risky long shot worked out says nothing about the quality of the decision, but can make a lot of people seem like gutsy mavericks in hindsight, while ignoring the fact that history could have just as easily had a different story to tell had things gone differently. If we break up the dynamics between process and outcome, we are likely to get the following scenario set.

Good Outcome Bad Outcome
Good Process Deserved Result Bad Luck
Bad Process Good Luck Deserved Result

Any decision should consider both the historical odds (base rates) as well as the individual circumstances reflecting the decision. In many cases, you’ll find that the base rate effect is so powerful that it overrides any individual considerations, at-least from the standpoint of having the best odds of a good outcome.

Let’s take the example of a commodity sector, and one of the more notorious ones: Airlines

A Brief of the Economics of Airlines.

“Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down,” he joked. “The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit.” – Warren Buffett

Air travel has no doubt been a revolution from a transportation standpoint, and has done a great deal to make the world a more interconnected place for travel and trade. Yet as an investment, the sector has been a death trap for investors. The reasons are fairly straightforward

  1. Commodity product leading to low pricing power: In recent years, the rise of no frills airlines & better price discovery through airline aggregators has led to people finding the cheapest option. As Indians, we are quite happy to choose the cheapest option when we feel it offers the most value.
  2. High fixed & Variable Cost: While the cost of ATF (Aviation Turbine Fuel) has moderated over the last couple of years, it still takes up a huge portion of the expense side. In addition, airlines have to pay lease charges, maintenance charges & airport taxes. Airline seats are a perishable commodity, which means that they cannot be stored as inventory and used later.
  3. High Competitive intensity: The airlines have been engaging in aggressive undercutting and price wars. It has an element of game theory to it – if noone made the first move with a price cut, all the airlines would have the ability to hold prices at a higher level. Substitutes like train travel do exist, but certain class of travelers are price-insensitive (business travel) and would pay any amount.

Against this backdrop, Interglobe Aviation, the company that runs the carrier Indigo Airlines, floated an IPO. There was massive interest, given that airlines were reporting better margins given the low cost environment, and Indigo had better operational efficiency ratios relative to the other players. As you can see, the IPO excitement lasted a few months, following which its more or less back down to a little over 10-15% where it started.

interglobe aviation.png

Now, I’m less concerned about the stock price and more to what the business reality that it reflects is. When you consider the two forces that  influenced the base rate here – the horrible economics of airlines, and the poor odds that come with IPO investing, you had a deck that is already stacked against a prospective investor. What’s worse, in a commodity sector, you are only as smart as your dumbest competitor, and you have Air India hemorrhaging money and deeply in debt, but kept afloat by means of government largess. What else could have played out?

  • Airline disaster: As Malaysian Airlines learned from its unfortunate mishaps, air crashes tend to put people off air travel, specifically off the carrier to which the incident happened. It is because vividness bias skews peoples perceptions of the risk (Airlines are statistically the safest form of travel). To this date if you ask someone if they would fly Malaysian Airlines, many would say no.
  • Oil prices could have spiked further than they have, destroying the margin gains that the airlines were briefly enjoying. The price of oil must eventually normalize to the marginal cost of production, and with that in the $50-$60 range, the price of oil was more likely to go up than go down.
  • Any gains made would benefit the customer, not the shareholder, as airlines would pass them on through price cuts as they tussled for market share.


The impact of the increase in air fare competitiveness has already impacted their Q1, with a 7.3% drop in profitability. I expect that unless the sector consolidates significantly, giving one player pricing power and economies of scale, it would be very difficult for airlines to grow on retained earnings alone, and would periodically have to borrow or raise fresh equity. While it is true that you could have made money by speculating on the IPO, betting on market psychology being euphoric is not what you would call an investment strategy.


Nassim Nicholas Taleb wrote in “Fooled by Randomness” that

“One can illustrate the strange concept of alternative histories as follows. Imagine an eccentric (and bored) tycoon offering you $ 10 million to play Russian roulette, i.e., to put a revolver containing one bullet in the six available chambers to your head and pull the trigger. Each realization would count as one history, for a total of six possible histories of equal probabilities. Five out of these six histories would lead to enrichment; one would lead to a statistic, that is, an obituary with an embarrassing (but certainly original) cause of death. The problem is that only one of the histories is observed in reality; and the winner of $ 10 million would elicit the admiration and praise of some fatuous journalist (the very same ones who unconditionally admire the Forbes 500 billionaires). Like almost every executive I have encountered during an eighteen-year career on Wall Street (the role of such executives in my view being no more than a judge of results delivered in a random manner), the public observes the external signs of wealth without even having a glimpse at the source (we call such source the generator.) Consider the possibility that the Russian roulette winner would be used as a role model by his family, friends, and neighbors.

While the remaining five histories are not observable, the wise and thoughtful person could easily make a guess as to their attributes. It requires some thoughtfulness and personal courage. In addition, in time, if the roulette-betting fool keeps playing the game, the bad histories will tend to catch up with him . Thus, if a twenty-five-year-old played Russian roulette, say, once a year, there would be a very slim possibility of his surviving until his fiftieth birthday— but, if there are enough players, say thousands of twenty-five-year-old players, we can expect to see a handful of (extremely rich) survivors (and a very large cemetery)”


I see speculation in the markets in the same light. There are many people who make dodgy decisions and will justify that the quality of their decision making from the outcome: they were right because they made money. Eventually though, the fact that they are rolling dice with bad odds will catch up to them. A smart investor studies the possible scenarios that are could play out with the companies he is investing with, and knows which hands to fold or avoid altogether because the odds are simply stacked against him.

Note: This is not a recommendation for or against Interglobe Aviation, I merely used it as an example.


2 thoughts on “Process vs Outcome: Consider Base Rates & Alternative Histories

  1. Speaking of investing in a commoditized sector , how does one explain the success of RyanAir and Southwest Airlines ? I think this is a case of applying second level thinking and looking for possible gems in an industry where the failure rate is high , but the companies which succeed , do so in a massive fashion sustainably

    1. Its not that its not possible to find outliers, its just that the odds are stacked against you. You can manage if you are extremely efficient and manage costs well so that you can be the lowest cost player, but its still an uphill battle. I think for an investor its much easier to find a sector where the general economics are good.

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