Survivorship Bias

Was reading the Sunday Times today when several “Unit Trust Providers” and “Actively Managed Funds” peddling their services through ads caught my eye. Whenever I do read those eye-candies, I can’t help but recall the miserable track record of active fund managers.

But how is it then possible that their ads, their validated track records and their promises still look so attractive? They are not allowed to “lie”, right?

Simply because of the Survivorship Bias. That logical error of concentrating on things that “survived” some process and ignoring those that did not because they are no longer visible.

survivorship bias

In the financial world, survivorship bias refers to the phenomena whereby the past records of existing mutual funds (aka unit trusts) are examined to determine various trends.  The problem lies in the fact that we are only shown the past records of currently existing funds—funds which ceased existence in the past are not included in their data.  And there are many of them as Fund Managers are not interested to “display” underperforming mutual funds for too long.  Quickly merge them with a successful one andsimsalabim!—off they go from the screen of transparency.

And funds do disappear at a significant rate. Over in the U.S. over the 15-year period, more than 58% of domestic equity funds were either merged or liquidated. Similarly, almost 52% of global/international equity funds and 49% of fixed income funds were merged or liquidated.

This “window dressing” tends to cause one to (falsely) conclude that the average mutual fund has performed better than is actually the case.  Due to survivorship bias, it is actually highly likely to (falsely) conclude that the average dollar invested in mutual funds performed better than average!

In reality, numerous studies confirm that up to 96% of actively managed mutual funds underperformed the U.S. market index after fees, taxes, and the above survivorship bias.

These stats are crazy but make much more sense when framed in terms of consumerism and popularity. It would be easy to place all of the blame on the financial industry for continuously rolling out funds year after year in hopes that a few of them will stick but that’s pretty much the way things work in most product-centric business models.

As long as investment consumers (that’s you and me) are willing to chase investment fads and past performance, fund firms will roll out new funds in hope of a few of them becoming big winners. The rest will fall by the wayside, never to be heard from again.

Thus, by investing in passive index funds (ETFs) with their typically lower annual costs—between 0.08% and about 0.8%—you will beat 96% of all actively managed and heavily advertised mutual funds hands down. Might be less sexy nor very exciting. But does growing your nest-egg have to be sexy and exciting.

Why people still like to hand over their hard earned cash to those Sales People from the banks and mutual fund companies is beyond rational behavior.

Avoiding the wrong stuff is often more important than finding the right stuff.

 

“Facts do not cease to exist because they are ignored.” — Aldous Huxley

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