May 23, 2017 | by James Behr Jr
In recent years, professional baseball player Yasiel Puig has served as an inspiration for young athletes yearning to go from “rags to riches.” Puig, a 26 year old migrant from Cuba, has captured the attention of baseball fans with his speed, strong arm, and gregarious personality. His ability and personality helped solidified a seven-year, $42 million deal from the Los Angeles Dodgers in 2012. However, Puig’s journey to the United States was riddled with danger and uncertainty. He tried to escape from Cuba 13 separate times, reaching the United States only after receiving the help of infamous Mexican drug cartel, Los Zetas. Due to the risk he took escaping to play baseball, many fans regard him as a hero.
Who the media chose not to idolize, however, were the thousands of Cuban citizens that desperately tried to escape, but did not make it. It was extremely uncommon for these migrants, who were often packed in miniscule boats and extremely malnourished, to ever even see the American mainland. Although it was a rare occurrence, Puig’s escape was thrusted into the spotlight rather than the misfortune of thousands just because it was considered successful.
This phenomenon is called survivorship bias, and is not unique to the sports industry. Survivorship bias is the logical error of concentrating on things considered successful and completely overlooking things that are not, typically due to a lack of visibility.
In finance, survivorship bias is often tied to the performance of various funds’ benchmarks. For example, mutual fund companies are able to shut down or merge funds in order to conceal their poor performance. This tendency results in an overestimation of mutual fund benchmark returns over time because it ignores the lackluster funds previously barred by the company. As the graph below portrays, the percentage of large-cap value funds that outperformed their benchmark in the past 15 years was 50%. However, when you take into account the funds that did not survive, the outperformance drops to 27%. This disparity results in the embellishment of mutual fund success by over 85%!
In addition, the reporting of hedge fund returns can be linked to the survivorship bias. Unlike mutual funds, hedge funds are not subject to many of the regulations meant to protect investors. According to the SEC, “Depending on the amount of assets in the hedge funds advised by a manager, some hedge fund managers may not be required to register or to file public reports with the SEC.” This provision allows hedge funds to disclose their returns/profitability on their own terms, making it difficult for investors to evaluate them.
Survivorship bias unfortunately clouds investors’ abilities to discern the worthiness of their investment. Investors may believe their mutual/hedge fund is consistently generating positive returns, but they have simply failed to see the inaccurate reporting tactics of the firm. In the mutual fund space, the survivorship bias creates the illusion of good management. Funds are usually rated by investment research companies, such as Morningstar, on a scale of 1-5 stars. While this rating can potentially provide valuable insight into the fund’s performance, the survivorship bias reveals the overinflating of true ratings because they exclude the failed funds. These ratings, which are prevalent in multi-media advertisements, provide the deception that these companies are profitable to invest in. Companies often gloat about the “ratings” of their funds in order to provide the delusion of superior management.
Although prevalent in many forms of investing, the survivorship bias can be avoided by aligning yourself with a more transparent advisor, who allows you to ask the necessary questions to ensure your investments are being reported accurately. Unlike typical advisors, fiduciaries are required to place their clients’ best interests ahead of their own and their firms’. As it can be difficult to discern whether your investment’s true performance is being hidden from you, it is important to demand a standard of truth and trust from your advisor.