Duncan Coker — Rivercast Capital Management — January 2020
Congratulations if you are reading this article you are a survivor! Granted on some days nothing seems to go right but compared to the alternative life is good. It tends to give us an optimistic outlook as it should. Optimism is a great thing and without it very little would actually get accomplished. On the other hand, it pays to be a realist as well. This is important when making long-term decisions like investing. In the process it is typical to envision future results by extrapolating from the past. This is fine. The key, however, is to account for all past and future events, not just the good ones. Otherwise, we are wearing rose-colored glasses and the world appears a bit too nice. In finance, medicine and other research fields this has a name – Survivorship Bias.
Once you start looking, you’ll find survivorship bias everywhere, a sort of Darwinian combination of luck, optimization and adaptation. A famous study once looked at returning combat aircraft during WW2. Planes were riddled by bullet holes on their wings. So engineers studied where to add extra protection. It was decided to add metal everywhere except on the wings. The logic was the returning planes had survived bullet holes on their wings. It was the holes in other parts of the plane that had caused them to crash and not return.
120 Years and Counting
Could the entire, cumulative US stock market return itself be an example of survivorship bias? Possibly. If you were a conservative investor living in 1900, you would view the US as an emerging market similar to Argentina, Russia or Romania. Today a balanced portfolio might be invested entirely in the US. In 1900, however, it was more likely to invest in a mixture of countries, perhaps a third each in the US, Argentina and developed Germany. History shows that in this balanced portfolio two of the three countries would be ravaged by inflation and wars. Investments there would lose nearly all of their real value. The US was the one survivor. We know that now, but our 1900 investor did not.
Thankfully, most equity research today factors in survivorship bias. The S&P 500 Index and Dow Industrial Index both make adjustments using specific rules and criteria. As a result, the index compositions are not what they were fifty or one-hundred years ago. This is good. We don’t want to invest in steam locomotives or telegraphs, but rather the modern-day equivalents like satellites or smart devices.
In some areas of finance, however, the adjustments are not obvious or do not occur at all. Survivorship bias becomes an issue when trying to identify an outperforming subset within a larger group – like a stock rotation strategy within the overall market. The subset might look better but is really just a random winner of survivorship bias. This bias can show up in the results of many offerings including equity strategies, factor models, hedge funds, private equity shops and ETF models.
How to Spot It
A few simple questions can identify if survivorship bias is inflating expectations. Make sure when looking at a firm’s prospectus you ask to see all the past returns including funds that have closed or strategies that have under-performed. Then take an average. Also, be sure to look for bias in the reporting period. Consciously or not, firms often cherry-pick for the best look-back period. For example, a long only fund would show much better returns starting in 2009 rather than 2007. This two-year change in reporting would boost prospective returns by over thirty percent due to the timing of the Great Recession.
Secondly, emotions often creep into investment decisions and survivorship bias relates to a common one, regret. The feeling of – if only I had invested in Amazon in 1998, I would be rich now. It is tempting to believe this, but it is an illusion. Only Jeff Bezos had any idea of how far Amazon could go. Also, during the late 1990’s there were hundreds of dot-coms with tremendous prospects, but nearly all failed. Focusing on the single big winner, Amazon, while ignoring the losers is a case of survivorship bias. It is better to refocus the regret-energy towards something positive like finding the next Amazon or better yet building it.
Lastly, I like simple rules and heuristics that I can apply-on-the fly. All else being equal, I subtract one percent from an equity strategy proforma to account for survivorship bias. With riskier investments like private equity I would discount by up to three percent from a prospectus. If the venture still looks good, then you have a winner.
Overall the issue with survivorship bias is not optimism, but unrealistic expectations. Inevitably we are disappointed when results fall short of what we planned. Far better would be to construct a realistic picture where expectations can be met or exceeded. Studies have shown that relative out-performance is linked to more happiness in our everyday lives and not just in our investments. So, lower your expectations, raise your spirits and have a prosperous 2020.
Rivercast Capital LLC is an alternative investment trading advisory specializing in managed futures. Clients include high net worth individuals and institutions. The firm follows a disciplined trading strategy based in statistical analysis. Rivercast seeks to provide clients with predictable returns that are uncorrelated with traditional investments while maintaining a targeted level of risk.
Rivercast Capital LLC is a registered CTA operating under regulation 4.7 of the CFTC. The firm objective is capital appreciation achieved through the leveraged trading of exchanged cleared futures contracts.