Survivorship bias is the tendency to focus on successful examples and ignore failures, leading to overly optimistic conclusions. In finance, this often involves excluding failed companies or funds from analysis, leading to misleading performance figures. Mutual funds are particularly susceptible to survivorship bias, with estimates suggesting that returns are overstated by almost one percentage point. Some argue that stock indices are also prone to survivorship bias, but to a lesser extent.
Survivorship bias is the error in the analysis of concentrating on processes or examples that were successful and ignoring or minimizing those that failed. The most common result of this is drawing overly optimistic or positive conclusions. In a financial environment, this usually involves an analysis that excludes companies or funds that have failed and are no longer in existence.
Within finance, the most common form of survivorship bias is tracking past investments, particularly mutual funds. For example, a company may launch 100 mutual funds. Five years later, you may have eliminated 25 of these funds entirely or merged them with other funds, both due to performance. This is normal behavior, as most financial firms don’t make much sense in keeping a consistently underperforming fund open.
The problem occurs when the company produces figures showing its performance over the past five years. An average figure may only include the remaining 75 funds because, of course, full five-year data is not available for the 25 that have been removed. This means that the average is much more skewed towards funds that perform well.
This can be extremely misleading as an investor looking at the number could expect a similar return on their investments over the next five years. In reality, the investments will most likely not do as well as the company will continue to launch some poorly performing funds. Some estimates suggest that survivorship bias could mean that estimates of return in the mutual fund industry are overstated by an average of almost one percentage point.
It is also arguable that some stock indices are prone to survivorship bias. For example, an index might track the 100 largest companies in a particular market. From time to time, this list will be revised to take into account changes in the size of the company. In many cases, companies leaving the list have been “downsized” because their share prices have fallen.
This means that at any particular time, the index will be less likely to reflect stocks that are performing particularly poorly. This survivorship bias means that the overall movement of the index is likely to be more positive than that of the broader market. The effect is not as pronounced as with mutual funds because some of the negative performance shows up in the index figure before the relevant stock falls. For this reason, some economists argue that stock indices should not be classified as showing survivorship bias.
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