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Survival of the Fittest? Survivorship Bias in Investing

man facing clouds during golden time

If you've ever sat down with a big bank "financial advisor" to discuss funds, you might've been amazed by the market-beating returns they advertised. Look at all those gains? Take my money!

Before you go all in, you should ask yourself:

Is this too good to be true? 

What about all the research showing how most active funds fail to beat their benchmark? 

Market data has repeatedly shown that an overwhelming majority (< 80%) of active managers fail to beat their benchmark over an extended time period.

So why do these funds look so good?

The answer is survivorship bias. Survivorship bias is looking only at winners (and ignoring the losers) to formulate your opinion. This leads to an incredibly inflated view of reality.

When funds perform poorly, they fall out of favour. They struggle to attract capital and eventually shut down. When these funds vanish so do their performance record. What remains are the strong performers with the attractive (i.e. marketable) returns.

In John Bogle's Little Book of Common Sense Investing, he studied equity funds from 1970-2016. Of the 355 funds that existed at the start of the period, 281 of them have gone out of business. That's an over 80% failure rate!

If I know who the strong performers are, shouldn't I just invest in them?

The problem is past performance is no indication of future performance. A 15-year sample (2000-2015) of US mutual funds demonstrates how rare it is for outperformance to persist. Of the 2,758 funds that existed in 2000, only 20% of funds outperformed through 2010. Of those out-performers, only 37% of them continued to outperform through 2015.

It's difficult to pick winners, odds are you'll end up picking an under-performer. When you opt for passive investing, you give up on outperforming the market. However, you'll end up outperforming the over 80% of investors who'll underperform the market. With very little effort to boot!

“Don't look for the needle in the haystack. Just buy the haystack!” 
― John C. Bogle


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