Survivorship bias isn’t a term you likely hear often, but you know exactly what it is. Ever listened to a sales pitch that opened with the most optimistic information, yet neglected to include the less-than-flattering details? This is a type of selection bias known as survivorship bias.
If you are contemplating an actively managed investment plan for your assets, it’s important to understand how survivorship bias can be used against you. Without knowledge of how financial planners and fund managers can skew their data, you can easily fall into the trap of overly-optimistic returns.
Cover your bases by starting with a financial advisor. While investment management is for risk tolerance and asset allocation, a vetted advisor can help you with effective estate plans, retirement and general financial advice.
What Is Survivorship Bias?
In finance, survivorship bias is when the performance of strong “surviving” assets is communicated while neglecting to include the poorly performing assets. Think of it as a way of not telling the whole truth.
As a result, prospective clients can fall prey to choosing a planner or wealth manager based on a false track record. One that shows glorified returns without accounting for liquidations, acquisitions, taxes and fees.
What To Know About Actively Managed Funds
Investing companies of actively managed funds are sought out for their expertise in the field. Many fund managers are products of the best educational institutions in the world. On paper, this makes them a popular selection to manage your investments for you. Plus, there’s the appeal of potentially beating the market and obtaining above-average returns. But keep in mind the following:
- Many firms are publicly traded: Publicly traded companies are at the mercy of their shareholders. In order to keep their stock price high and their shareholders happy, fund managers must produce competitive returns.
- Data can be manipulated, legally: To receive a holistic view of a company’s performance you need to look at the good and the bad returns. Omitting the poor performers and focusing on the best performers is a form of data manipulation.
- Active trading makes them money: Think of fund managers as car salesmen. They earn more by selling a used car than a new one. Consider passive investing as a new car.
Even with passive investing being the inexpensive option all while producing a more consistent return, many fund managers push active investing for their own benefit.
The impact of survivorship bias is a false presentation of a company’s performance. Mutual funds don’t all perform the same; some are survivors while others fold. This is a product of both the market performance and the fund manager’s ability to shift investment strategies to react to market shifts.
When a mutual fund performs well, management will reference its performance when showcasing its annual/quarterly results. When a fund closes as a result of poor performance, acquisition, or liquidation, management might opt to intentionally fail to include these results in their observations.
Example of Survivorship Bias
Here’s an example of survivorship bias presented in mutual fund returns:
From the chart, we see that the company held four funds. Of these four, two were closed with losses on the initial investment. If a fund manager were to present the entire portfolio performance it would show an average return of 5%. If the manager omitted the closed funds and showcased the active funds, the return becomes 14%, a sizable increase to turn the heads of potential clients.
A firm’s success should be measured holistically. Being optimistic has its place in performance reviews, but it cannot be the only indicator you look for when choosing who will manage your investments.
The Bottom Line
Passive investing has always been the front-runner for most investors. Compared to active investing, it’s less expensive, less risky, and holds consistency in performance. If you do venture into having a firm actively manage your investments, be sure you’re not blinded by overly confident forecasts. At the very least, ask what the firm is doing to omit survivorship bias from its metrics.
Tips for Investing
- Whether you’re considering getting started with investing or you’re already a seasoned investor, an investment calculator can help you figure out how to meet your goals. It can show you how your initial investment, frequency of contributions and risk tolerance can all affect how your money grows.
- Consider talking to a financial advisor about active vs. passive investing to help decide which one is a better fit. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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