Are You Committing "Survivorship Bias?" 4 Things New Investors Should be Wary Of

Survivorship bias occurs when people focus on the successful assets or funds in an investment portfolio while ignoring or overlooking those that have failed or underperformed. 

It's essential for new investors to recognize this phenomenon, as it can lead to inflated expectations and ultimately cost them money in the long run. 

Understanding survivorship bias and how it works will help investors make smarter decisions as they start investing and evaluate potential opportunities. Here's what you need to know.

Survivorship bias is the tendency to focus on successful investments while ignoring the poor performers that have dropped out of a portfolio. 

This bias often appears in mutual funds, where investors may only be shown data on top-performing funds, not those that have failed or closed.

For example, if a mutual fund company only shows you the returns of its best-performing funds and omits the poor performers that were quietly shut down, you may be left with a skewed picture of the fund's overall performance.

Imagine an investor looking at a fund that claims an impressive 9% rate of return over the last 10 years. However, what they may not realize — or fail to consider — is that the fund has closed or merged several underperforming segments during that time.

In this example, the numbers being shown reflect only the "survivors" and not the whole story, giving an inaccurate picture of the fund's overall performance.

The most significant impact of survivorship bias is the creation of a false sense of optimism. If an investor only sees the successful assets in a portfolio, they might assume that the investment is more resilient or successful than it truly is. 

This can be particularly misleading when evaluating mutual funds or other large investment groups, where underperforming assets are quietly removed from the equation.

This bias can make it difficult for investors to accurately assess the risk associated with their investments. And, if you're basing your decisions on incomplete data, you might be taking on more risk than you realize.

Survivorship bias can lead investors to believe that poor performance is the only reason funds close, but that's not always the case. There are several reasons why an investment fund may shut down or merge with another fund.

Some funds close because they have reached their target goals or have become too large to manage effectively. Others may close due to poor performance or because the asset holders want to limit new investments. Occasionally, funds can also close as part of larger corporate mergers or acquisitions.

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While survivorship bias involves focusing only on successful investments in a portfolio, reverse survivorship bias occurs when low-performing assets remain in the portfolio despite more successful alternatives being available. 

This is less common but still worth noting, as it can distort performance data in the opposite direction.

Some indexes, like the Russell 2000, show examples of reverse survivorship bias. Because this index tracks a broad range of small-cap companies, it can include some poor performers even as stronger companies are added. 

This creates a drag on the overall performance and can make the index seem weaker than it truly is.

While you can't eliminate survivorship bias entirely, you can reduce its impact on your investment decisions.

First, vet your data sources carefully. If a fund's promotional materials only show the top performers, dig deeper to learn about the whole portfolio's performance, including any closed funds.

It's also essential to use current information. Old data may reflect a portfolio that no longer exists in its current form, making it difficult to assess its true performance.

Lastly, be wary of relying solely on historical performance. Survivorship bias can distort how past successes are presented. This makes it crucial to consider not just what has succeeded but what has failed and why.

Consider partnering with a trusted financial advisor to help provide you with a more complete picture. Professionals can often access data that casual investors might overlook.

Survivorship bias can cloud an investor's judgment by only highlighting the successful aspects of a portfolio while ignoring failures or closures. 

Understanding this bias and how it affects investment performance is critical for making more informed decisions as you plan your financial future.

Are you looking at the full picture when evaluating your investments, or are you only seeing the success stories? By recognizing the potential for survivorship bias, you can take steps to make more well-rounded investment choices and protect your wealth.