Financial Daily from THE HINDU group of publications
Sunday, May 22, 2005
Financial Daily from THE HINDU group of publications Sunday, May 22, 2005 |
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Investment World
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Stock Markets Columns - Simple Economics Survivorship bias B. Venkatesh
CONSIDER this. Your friend has a simple trading strategy. She buys stocks on days when she is unable to get a copy of a financial daily from the newsstand. She claims that this strategy has generated returns in excess of 50 per cent! If you are a student of finance, chances are you may suspect that this strategy suffers from survivorship bias. What does this mean? Suppose your friend is unable to find a copy of a financial daily on 20 occasions in a quarter. She, however, chooses to trade only on 7 out of these 20 occasions. What if the market actually went down on the other 13 occasions? In other words, your friend's conclusion suffers from a bias because she has not looked at all 20 occasions to see if the strategy is profitable. But why call this as the survivorship bias? An example based on mutual funds will throw some light on this. You read a research report that states that large-cap value is the best investment style. The reason? All 25 funds that follow this investment style have handsomely beaten the benchmark index by 75 per cent in each of the last five years! The report may not, however, state that that there were 100 funds following such strategy 5 year ago. Each year, the unsuccessful funds had to close shop because investors moved their money to more successful ones. The fact then is this: for every successful fund, three unsuccessful ones closed down. The report, therefore, suffers from survivorship bias. That is, the report shows large-cap value as a very profitable investment style because it takes only the "surviving" funds to compute the performance. And since the "surviving" funds are necessarily the best ones, the performance carries an upward bias.
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