Should characters be developed outside of a story before writing or during the course of events and just letting everything flow naturally?
Whatever works I guess I do both - I write short stories some of my characters keep blogs, I 'cast' them with actors, make up a scrapbook with ideas about their clothes and homes. Word boxes with words they use that I wouldn't. Give them a theme tune, Talk to them etc However nothing develops a character as well as a story - they will mutate and evolve over the story.
Both. You have to have at least a vague idea of who your character is when you start writing, because, well, otherwise I don't think it'll be very easy to figure out how the story works out. Generally I think it's good to have a clear idea of what the character is when you start out the story, and then as you write, allow them to change and develop when it seems like it's appropriate. It's good to keep an open mind to see where they could go.
I like to have a pretty good idea of who the character is before starting a story. They will usually develop a lot through the story as well, but as my stories are often character driven, it's difficult if I don't have a good grasp of who the character is when I start. If your story is more plot driven, I think it might be better to start out with a basic character and see where it takes them.
They're characters. They have a personality. Things they like/dislike/do/don't do etc. Of course, they'd be developed outside the story (unless you're writing about a newborn baby's growth into adulthood). Character development is a different aspect, and it happens within the context of the story.
I prefer to have some basic ideas/motivations for my characters, then let them grow as the story progress. It's the way that feels the most natural to me. As the story progress I learn more about the characters, sometimes they even surprise me The problem about this approach is that I have to go back and rewrite old parts of the story from time to time, just because I see new sides of a character which make the old one obsolete.
Sometimes I feel like that's the only way to make a character. Especially if I want to imagine how they would react to the same situations I've been in.