What is Survivorship Bias?

“Dead men tell no tales”. This holds for market indices and the performance of mutual fund managers. While the fittest ones survive, those not existing anymore should not be buried. People can make a well-informed and rational decision only after listening to a story in its entirety - giving attention to those who are alive to tell their story and those who are dead and can’t defend themselves. Below is an explanation of what the ‘survivorship bias’ or ‘winner takes it all’ approach is and why it is faulty.

What is Survivorship Bias?

Survivorship bias is a sample selection bias that occurs when people consider only successful data points to represent the entire data set. In the investing world, survivorship bias can be understood as people's belief that the stocks that could survive in the market or ‘existing stocks’ represent the entire market. They tend to disregard the stocks that tanked in the process. In other words, successful stocks are exaggerated, and suboptimal stocks are consigned to oblivion. Survivorship bias can occur while evaluating market indices and mutual funds' performance.

Survivorship bias in mutual funds

A mutual fund collects money from various investors. Further, it invests that money in multiple assets such as stocks and bonds to generate returns.

Investors pool their money with mutual fund houses to multiply their wealth. These mutual fund houses are run by professionals called fund managers who manage their money by investing it further in multiple assets like bonds and stocks. Fund managers close or merge the funds with other funds if they fail to generate sufficient profits. What remains visible to the naked eye are the funds which could garner enough profits.

For example, a fund manager manages 10 funds, out of which 30% could not become profitable by the year-end. People analyzing the fund manager’s performance at year-end would not know anything about the 3 funds that went bust during the year. Their sample universe will only have 7 good funds, which is far from reality.

The public's focus is primarily on the existing mutual funds because investment houses terminate the funds that do not work well. In the case of stock market indices, only the existing stocks are in the public eye, making them a representative of the entire market.

Survivorship bias can lead to crooked judgements in the following ways:

• The inflated data leads investors to expect unrealistic returns from that asset class.
• Investors may negatively perceive the 'underperforming' assets/funds and decide to discontinue them. In hindsight, this may prove to be a wrong decision.

Evaluation of any fund managers should be based on all their funds in entirety, including funds that are no longer present for investment. Choosing only the optimistic returns shall, in all likelihood, be an incomplete and skewed reflection of reality.

Factors to consider

Factors to consider to understand when survivorship bias can occur include:

1. When success is overstated, and failure is understated.
2. It can occur while evaluating mutual fund managers focusing solely on their best performing funds, feigning complete ignorance of their projects which went bust. It can also be seen while analyzing the performance of market indices.

Reverse Survivorship Bias

Reverse survivorship bias reflects people’s exclusive focus on stocks/funds that did not perform well. It is less prevalent than survivorship bias. The overall return of the index or mutual fund is made less attractive as the high-performing stocks have been ousted from the group.

'Path dependency' or resistance to change is closely associated with reverse survivorship bias. People are prone to continue using an old product even if newer and better alternatives are available to avoid the uneasiness of choosing new things. In both reverse survivorship bias and path dependency, people are stuck with low performing stocks/funds.

Conclusion

Where there are roses, there are also thorns. It is alright to be dazzled by double-digit growth numbers of funds until one also has an eye for the funds that tanked. To be a successful investor, one needs to have a broad perspective of things. Being aware of survivorship bias can help people make better investment decisions.