Updated: Jan 18, 2021
During World War II, returning bomber planes often made their way back to the landing site riddled with bullet holes. As a result, it prompted the United States armed forces to take steps to increase their armor and better protect their planes. They were faced with one main question: where should they aim to increase armor and protect these planes? The planes that returned were peppered with bullets distributed along the wings and body of the planes. It seemed that they needed better armor everywhere.
Abraham Wald, a statistician tasked to help with this mission, saw that it would be a mistake to upgrade the areas where most of the bullet holes were found. Why? Planes that came back were able to sustain and survive the damages. Instead, he wanted to take a closer look at the planes that did not return and were thus more likely damaged in truly vulnerable areas like the engine.
As humans, we are tempted to concentrate our attention on the things that are successful. We are often blinded to the many failures that do not make it through the selection process, just as many World War II armed forces veterans were blinded to the planes that had crashed. This process is known as survivorship bias.
This survivorship bias can easily be tied into the world of business and finance. For every Steve Jobs story, there are thousands of people and businesses that have failed without any sort of recognition or fanfare. We hear of successful startups that come from the convenience of a home garage, but we never see the hours of sweat and labor that brought them into the limelight.
In the world of investing, the survivorship bias has many parallels. You have probably heard about Jim Simmons and the incredible returns he has made in his medallion fund, but what about the hundreds of thousands of active traders who went bust? There is a much larger pool of people who have made equally risky bets, failed, and left their investment careers quietly.
Warren Buffet is a household name due to his incredible track record, but you never heard about the millions of investors and professional active managers who underperform the market.
It is true is that you simply do not become as wealthy as Jeff Bezos or Bill Gates by holding a well-diversified portfolio. By the same token, you do not gain wealth by holding onto an under-diversified portfolio either. Statistically speaking, the latter is more likely to end in bankruptcy than anything else. Since 1926, only four percent of companies accounted for all wealth creation in excess of one-month Treasury bills.
This principle also applies to actively managed mutual funds. Survivorship can distort the data in a positive direction. It makes the average return look even higher because underperforming mutual funds tend to close and slip away quietly. Only the numbers from the survivor funds, which essentially excludes the lowest-performing in nature end up in the averages which inflates the already subpar performance for these actively managed funds.
The moral of the story is that survivorship bias has a way of distorting our reality when it comes to financing and investing. We are given just a small piece of the picture, usually a piece that looks successful and glamorous. Instead, we should be actively seeking the entire landscape if you truly want to do what is best for your financial future.