Survivorship Bias or How to Hide Failing Mutual Funds

I have written previously about cognitive biases. Even since I learned how much financial success and failure is governed by psychology from Dr. Dave, I have paid much more attention when I spot people mentioning cognitive biases.

One of the most insidious ones is survivorship bias. It is what happens when past failures vanish from our sight, and all we can see is success. We are pressured to accept almost any reason couched by the survivors, real or imagined, and use it to drive future decisions, right or wrong.

A thought experiment

The best example is one I read in Where are the customer’s yachts? In the book, the author mentions a thought experiment where you hand out quarters to 100,000 different people. Everybody flips their coin. If you flip heads, you stay in the game; tails and you’re out. One flip, and 50,000 people are out by natural odds. Flip again, and you’re down to 25,000. Suffice it to say, after 10 flips, there would be a hair less than 100 people left in the game.

At that point do you think anyone would be listening to the losers? Or would they prefer to ask someone who had flipped heads ten times in a row how they did it? I think you know the answer. At that point, the winners would probably be giving tips on how to flip the coin, how to catch it, how to stand, which direction to face, and any number of other ridiculous ideas. And we would all be drinking it in. Nevermind that 99,900+ people had just lost. That would be old news!

Survivorship bias overestimates past mutual fund performance

What else explains the fact that in one study, only eight out of 203 mutual funds beat their relative indices? Most funds fail at building wealth, but somehow that isn’t a highly recognized fact. Instead, most of my friends are still slugging it away in their corporate jobs, stuffing money into their 401k-wrapped mutual funds.

Here’s a tidbit that might stun you. Mutual funds that fail are shut down and never heard from again. Their assets are reallocated to another fund. The mutual funds of today aren’t the same ones from ten years ago. Do you think that type of past performance is factored in risk assessments by your financial planner?

Heck, I experienced this once, years ago. I didn’t think much of it. Instead, I figured they were routing my money into something better (hello confirmation bias!) If I was to go back to that same financial institution and evaluate all their funds, I might get a certain number on general rate of success. But that fund I used to have wouldn’t be included in that metric of success. See why this survivorship bias is insidious? It’s not evil or conspiratorial. It simply causes the data of failures to vanish without effort.

How can we combat these biases? 

Let’s try something different. Go visit Berkshire Hathaway’s website and start reading their annual letters to the shareholders. You’ll find data going back to 1977 written by Warren Buffett himself. Read them all and you will probably understand much more intimate details about business and finance.

Next thing: Go and read every blog entry by Jeff Brown, aka the Bawld Guy, a real estate investment broker, especially the ones before the video segments (sorry Jeff, but I miss the writings!) That might take some time, since it goes back to 2006. An article-a-night will help. You will get another perspective on real estate and how it stacks up against mutual funds and stocks.

I have spent at least a year reading both sources of information. This might sound narrow and focused on just a couple perspectives, but it actually shattered my established set of beliefs of the mutual fund industry. When that happens, you are willing to read more articles by other people, and review them more objectively.

No longer did I read things and filter them through my impaired assumptions. Instead, I started applying a lot more critical thinking and began to notice when writers used generalities & assumptions vs. specifics & evidence. The ones lacking evidence stick out like a sore thumb, and sadly appear to be in the majority.

The outcome?

At the Wealth Building Society, we try to point out evidence-based financial realities and cognitive biases. That’s why I’m hoping this blog can shake your financial foundations and help you start objectively looking at wealth building advice with a critical eye. And if you want to talk, feel free to contact me.

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