Survivorship Bias and Your Financial Well-Being
As we covered in our last post, “Why the Guru’s Glass Is More Than Half Empty,” active managers who seek to beat the market at its own game face incredibly difficult odds of success. One trick is to cloak this reality with a research flaw known as “survivorship bias.”
A Survivorship Bias Analogy You Can Take to Heart
A financial study is tainted by survivorship bias if it fails to include returns from typically underperforming funds that have been closed or merged into other funds during the analysis period. In other words, the (likely worst) results simply disappear from the final count.
To illustrate how survivorship bias can prey on reports of supposedly glowing past performance, consider how it might affect the similar but different environment of medical research. Imagine a study concluding that a new miracle drug, “ActTradicon” was responsible for dramatic improvements for those at risk for heart disease. The study’s authors claimed that a whopping 80 percent of those who took ActTradicon for 10 years remained free from heart disease, compared to the control group, half of whom had required standard treatments to ward off heart failure.
Sounds great, doesn’t it? But what if reality told a different tale? What if, compared to their control group counterparts, the ActTradicon-popping participants had actually experienced four times the number of deaths during the 10 years? If the study were tainted by survivorship bias, these poor souls would be omitted from the final results. In other words, the ActTradicon survivors would be the only ones counted. Logically, they would likely be the healthier individuals who probably would have been fine or better with standard medical care.
Suddenly, ActTradicon doesn’t seem like such a great idea after all.
Survivorship Bias in Financial Research
Thankfully, tightly regulated medical drug studies are free from these sorts of biases. But in the financial arena (even though we might argue the stakes are nearly as high), not all studies are as soundly constructed, nor are they as strictly controlled. Before swallowing the conclusions reached, it’s critical to determine whether survivorship bias may have played an insidious role in the results.
In our next post, we’ll cover another reason why it’s so important to be on the look-out for survivorship bias: Disappearing funds are far more prevalent than most investors realize.
