Survivorship bias risk is critical to understand🍰 when evaluating investment opportunities. The bias might be among the most p🌱revalent cognitive biases in finance and investing—and almost certainly so among the financial media.

This risk arises from focusing on “surviving” or successful investments while overlooking those that have failed or been discontinued. This bias can lead to an overly optimistic view of potential returns when reviewing investment funds, as poorly performing funds are often closed or removed from performance data.

Reviewing survivorship bias risk demonstrates the importance of looking beyond surface-level performance measures and the broader context of fund management. Below, we’ll explore the implications of this risk for investors, its relationship to financial reporting, and strategies for mitigating its impact on investment decisions.

Understanding Survivorship Bias Risk

Survivorship bias risk involves evaluating a situati🔴on or drawing conclusions based mainly🌸 on people or things that are prominent or visible at that time. This usually occurs after some sort of selection or separation process has occurred. 

Survivorship bias is a problem when the characteristics of survivors differ from those of the overall original population or the target audience. This normally occurs because the selection process is not random, but is biased in some way for or against certain traits, characteristics❀, or behaviors.

The Origins of Survivorship Bias

During World War II, the U.S. military was looking for ways to cut its massive aircraft losses 🍸to enemy fire. They examined the bullet holes on planes that returned from missions, noting that certain areas, like the wings and fuselage, had more damage. For ൩a while, they reinforced these areas, but to little effect on the rate of aircraft returning to American bases.

However, statistician Abraham Wald pointed out a crucial flaw in this thinking. The military was only examining planes that had survived, not those shot down. Wald suggested that the areas with fewer bullet holes on the returning planes—like the engines—were actually the most critical. Planes hit in these areas were not returning at all. Instead, the extra metal was being put exactly where the planes had shown they were surviving without it. This insight led to a more effective armor placement strategy, highlighting the importance of considering what isn’t revealed in data analysis.

Survivorship Bias and t☂he Mythology of the Visionary CEO

In the investment community, survivorship bias is often found in historical stock or fund performance analyses and the narratives surrounding successful companies and their executives. No doubt, there’s much to learn from these firms and people. That said, on Wall Street and in the broader financial and news media, this bias frequently appears in the glorification of successful CEOs𓄧 and companies while overlooking those who have failed.

Business magazines and news outlets tend to profile and interview executives of thriving companies, presenting their strategies and decisions as foolproof blueprints for success. This creates a skewed perception that all CEOs of major companies are visionaries or geniuses, ignoring the countless executives whose companies have failed or underperformed. It can also lead to misattribut⛎ing the reasons for a company’s success.

While some CEOs and companies do genuine strategic insight, others may simply benefit from favorable circumstanceꦰs, timing, or even pure luck. Many factors outside a leader’s control can contribute to a company’s success or failure in a complex business environmen🐬t.

The idea that “someone has to succeed” is crucial. In any competitive field, including business and investing, there will always be top performers simply because of st🧸ati💦stical probability, even if success is completely random. This doesn’t necessarily mean the survivors are inherently more skilled or insightful than their peers.

For example, if 1,000 people flip coins purely by chance, a few will likely flip several heads in a row. If we only focused on these “successful” coin flippers, ignoring al𝔉l others, we might mistakenly attribute their results to skill rather than randomness.

This phenomenon can lead to the following:

• Overvaluing executive talent: Companies may overpay for CEOs who have been successful in the past, not recognizing that their previous success may not be replicable.
• Misidentifying best practices: Business practices of successful companies may be widely adopted without recognizing that these practices may not be the cause of success or may not work in different contexts.
• Underestimating the role of luck: The role of fortunate timing, market conditions, or other external factors in a company’s or investor’s success may be underappreciated.
• Creating unrealistic expectations: Aspiring entrepreneurs or investors may have overly optimistic views of their chances of success based on high-profile success stories.
  

The latter is crucial: the fake-it-until-you-make-it ethos of the latter 2010s (and still too frequently defended in some outlets even today) is fallacious on many grounds, including the idea that if successful CEOs evinced a fantastical belief in their success, treated their subordinates with the anger management skills of a charging rhinoceros, or lied through their teeth about their products, then those survivors are the ones to emulate—not the business fundamentals of countless other successful firms that’s harder to repeat.

How to Mitigate Survivorship Bias

T꧅o mitigate these risks, you can do the following:

• Study both successes and failures to get a comprehensive view of what drives outcomes.
• Consider the role of external factors and timing in success stories.
• Be cautious of attributing too much importance to individual leadership in complex organizational successes.
• Recognize that past performance, especially in small samples, may not be indicative of skill or future results.

How This Works in Investing

Survivorship bias applies to investment strategies as well. Many tactics tha♐t have worked in the past are touted as surefire methods for future success without considering the many similar strategies that may have failed.

For example, when evaluating the long-term returns of a group of 澳洲幸运5开奖号码历史查询:mutual funds, databases, and analyses may inadvertently exclude funds that closed 𓆉or were merged away, typically because of poor performance. This can artificially inflate the average returns of the remaining “surviving” funds.

Some key ways that survivorship bias risk can impact investment analysis and decisions include:

• Overestimating past performance: Analysts may overstate the historical returns of a particular investment strategy or asset class by only looking at existing funds or stocks.
• Underestimating risk: Failed investments disappear from data sets, potentially masking specific strategies’ true volatility and downside risk.
• Backtest 澳洲幸运5开奖号码历史查询:overfitting: When developing quantitative trading strategies, testing only on surviving stocks can lead to overfitted models that perform poorly out of sample.
• Misattributing skill: Fund managers or strategies may appear more skillful than they truly are if their poorly performing competitors are excluded from the analysis.
• Skewing benchmarks: Market indexes and 澳洲幸运5开奖号码历史查询:benchmarks that do not account for delisted stocks may provide an inaccurate picture of overall market performance.

To mitigate survivorshi🐼p bias ris﷽k, investors and analysts might do the following:

• Use databases that include historical data on defunct funds and delisted stocks.
• Explicitly account for mergers, acquisitions, and bankruptcies in analysis.
• Be wary of long-term backtests, particularly in strategies with high turnover.
• Consider the full universe of investment options that existed at the beginning of the evaluation period.
• Adjust benchmarks and peer comparisons to include non-surviving entities.
  

Survivorship Bias Risk and Other Risks

Survivorship bias risk is just one example of the various types of risk an investor must consider when making investment decisions or planning their long-term strategy. Investors should also consider related types of risk in an investment fund. Risks related to survivorship bias that investors might encounter include the following:

The Bottom Line

Survivorship ꦚbias is a pervasive risk in financial analysis and often results in decisions that can lead to overly optimistic assessments and flawed strategies. It’s a powerful reason to remind oneself that, as the financial cliché goes, past performance isn’t indicative of future results.

Investors may overestimate potential returns and underestima🌊te risks by focusing only on successful investments or strategies that have endured. This bias can affect everything from stock selection to fund performance evaluation and market index construction. Investors and analysts must work to counteract survivorship bias to make better, more informed decisions.