survivorship bias

Don’t Let Your Brain Play These Tricks on You

5 common behavioral finance traps

Key Takeaways:

  • Understanding both the “how” and the “why” of irrational behavior can be invaluable to investors.

  • Research shows that many individuals are overconfident, under-diversified, short-sighted and often swayed by the media.

  • Learn how to protect yourself from your basic instincts.



Imagine world full of “rational” people who could maximize their wealth while minimizing risk. The ratings would be terrible for every cable-TV money show and there would be a lot fewer financial advisors in business. Rational individuals would assess their risk tolerance honestly and then determine an investment portfolio that met their income needs within their risk comfort zone. However, we know that most individuals are NOT capable of being rational—research has proven this time and time again.

Behavioral finance encompasses a body of theoretical and empirical academic research that seeks to explain how and why people, especially investors, do not act in a rational manner.

First let’s look at how investors behave irrationally:

  • Their portfolios are not sufficiently diversified.

  • They trade actively with high turnover and high transaction costs.

  • Too much of their wealth is tied up in their employer’s stock or in their own company’s stock if they’re a business owner.

  • They’re over-concentrated in or stocks of companies within their own industry or their immediate geographic area.

  • They tend to buy, rather than sell, companies that are mentioned positively in the news.

  • They tend to sell their winning investments while holding onto their losing investments far too long in a futile chase back to “break-even.”

Now let’s look at five common reasons why individuals behave so irrationally:

1) Recency bias.  We tend to make our decisions—especially financial ones—based on what happened to us most recently. Suppose a stock we just unloaded zoomed up by 50 percent a week after we sold it. Ouch! Then suppose there’s an earnings miss on another stock we’re holding, even though our disciplines might tell us to sell it. We’re scared to death that the same timing mistake we just made will happen again – i.e. the stock will zoom back up right after we sell it.

2) Anchoring.  In one sense it’s about having a mental stake in the ground to give you a framework for making decisions. For example, news about new market highs is blaring every day (Dow 26,000!  S&P 2,800!). And people are saying to themselves: “New highs! New highs! It must be time to sell.” But think about it. New highs are usually a positive sign for the market. We get anchored into these numbers and they distort our thought process. As a general rule, introverted people tend to be more skeptical. And that mindset can really hurt us in our investing because you miss out on opportunities or give up on an investment too quickly. On the flip side, extroverted people tend to be optimistic most of the time, but that can also hurt you as an investor, because you tend to expose yourself to too much risk—again and again.

3) Mental accounting/fallacy of breakeven.  Picking winners is not the big problem for most investors (do-it-yourselfers and many pros). The problem is that they can’t let go of their losers. When you’re holding on to your losers, your ego gets in the way. You tell yourself: “I’m know I’m right about this stock, the market just hasn’t recognized its value yet.” Or, you tell yourself, “I did so much work analyzing this stock, I can’t bail on it now.” So, you start doing all kinds of mental accounting and then at the end you tell yourself that you’ll sell the stock just as soon as it gets back to breakeven. And that’s an ABSOLUTE KILLER in investing.

When you hold on to a losing investment for too long trying to get back to break even there’s an opportunity cost. All those months and years that your money is tied up waiting to get back to breakeven means it can’t be deployed elsewhere in a more profitable investment.

4) Confirmation bias. Let’s say you have a great investment thesis, but you want it confirmed before you pull the trigger on it. So, you run around trying to get confirmation bias from all your smart friends, your broker and the Wall Street pundits whose picks you typically like.  Unfortunately, you’ve got a self-selected group of people who generally share your world view. If you’re honest with yourself, you’ll see they’re wrong more often than right.

Confirmation bias illustrates the danger of following the news media all day long and the danger of blindly following managers who have had the “halo effect” (i.e. hot hand) for the past several years. So you dive in and start following them and it often doesn’t work out. Remember those elite gurus who predicted that the housing crisis 10 years ago would trigger the global financial crisis. They made a fortune! So many investors piled into their funds waiting for them to work their magic again—and a decade later they’re still waiting.

5) Gambler’s fallacy. This occurs when you believe a purely random event is really NOT really random and that it’s going to continue to happen into the future. You start loading up now on FAANG stocks (Facebook, Apple, Amazon, Netflix, Google) because you think they’re going to stay hot forever. You predict the next coin flip is going to land heads because the last 20 flips also landed heads. In reality, you have no way of knowing which side is going to land facing up. It’s completely random, just like so much of investing is. Most of the time, we have no control over what’s going to happen in the market. This fallacy that you actually have control due to some event that is random that you think is NOT random.

Conclusion

Behavioral finance literature serves as a reminder why it so important to protect yourself from you basic instincts—especially when markets are volatile. Safeguarding your wealth is a responsibility, not just to yourself, but to your family and the causes you support. Don’t hesitate to contact me if you suspect that you, or someone close to you, might be drifting from your long-term financial plan.

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

 

The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.

How Survivorship Bias Can Skew Your Views on Mutual Fund Performance

It’s important to avoid treating the market like a popularity contest by chasing out-performers or running away from the underdogs. But neither do most investors want to go into the market entirely blind. For that, there are database services that track and report on how various fund managers and their offerings have performed.

Besides ample evidence that past performance does not predict future returns, there is another reason we advise investors to proceed with caution when considering past performance: Many returns databases are weakened by survivorship bias. 

With respect to mutual funds and similar investment vehicles, survivorship bias creeps in when only the returns from surviving funds are included in the historical returns data you are viewing.

Here is what happens: As you might expect, there is a tendency for outperforming funds to survive, and for under-performers to disappear. When a fund is liquidated or merged out of existence, if its poor returns data disappears as well, overall historic returns tend to tick upward. 

As such, you may end up depending on past performance data that is optimistically inaccurate. 

Here is an article that further explains how survivorship bias works. In addition, consider the following illustration from Dimensional Fund Advisors’ report, The US Mutual Fund Landscape 2016. It illustrates how survivorship bias can skew your view on fund performance. 

Mutual Fund Img 1.png

 

In the beginning – in this case January 1, 2001 – there were 2,758 US equity mutual funds. Now fast-forward 15 years to December 31, 2015. By then, only 43% of those funds (roughly 1,186 funds) had survived the period. Out of the survivors, only 17% (about 469 funds) had both survived and outperformed their benchmark over the 15-year time-frame.1

In the illustration above, you can readily see that the small blue box in the lower-right corner represents relatively low, less than 1:5 odds that any given fund in January 2001 went on to outperform its peers by the end of the 15 years. 

If a database instead eliminates the “disappeared” funds from its performance data, the larger gray box disappears from view as well, as in the illustration below. Without this critical larger context, you may conclude that those 469 outperforming funds only had to compete against the 1,186 survivors, versus the actual universe of 2,758 funds. While it may seem as if nearly half of the fund universe has done well, in reality, the less than 1:5 odds have remained unchanged.

You see 100% of what has survived and just over 40% outperforming!

You see 100% of what has survived and just over 40% outperforming!

But wait, maybe you could “take a look at the past performance, pick the funds that have outperformed after the first 10 years, and pile up on those seeming winners. Dimensional’s report also shares the results from that exercise:

The left-hand side of this diagram shows the funds that outperformed (in blue) and under-performed (in gray) during the first 10 years of the 15-year analysis.2 You can see that 20% outperformed their respective benchmark then. The right-hand side of the diagram shows what happened to that outperforming subset during the next five years. Only 37% of the initial “winners” continued to outperform. This demonstrates that is it is extremely hard to predict “winning” mutual funds based on past performance. Your odds are even worse than what you can expect from a basic coin toss! 

So let’s take a moment to reinforce our ongoing advice: Invest for the long-term. Instead of fixating on past performance, focus on capturing future available returns within your risk tolerances and according to the best available evidence. Aggressively manage the factors you can expect to control (such as managing expenses) and disregard the ones that you cannot (such as picking future winners based on recent past performance). 

These principles guide the actions we’ve advised all along. We will continue to embrace them unless compelling evidence were ever to inform us otherwise. They are the ones that serve your highest financial interests, which is our highest priority as your advisor.  


1.  Beginning sample includes funds as of the beginning of the 15-year period ending December 31, 2015. The number of beginners is indicated below the period label. Survivors are funds that were still in existence as of December 31, 2015. Non-survivors include funds that were either liquidated or merged. Out-performers (winners) are funds that survived and beat their respective benchmarks over the period. Past performance is no guarantee of future results. See Mutual Fund Landscape paper for more information. US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago. 

2.  The graph shows the proportion of US equity mutual funds that outperformed and under-performed their respective benchmarks (i.e., winners and losers) during the initial 10-year period ending December 31, 2010. Winning funds were re-evaluated in the subsequent five-year period from 2011 through 2015, with the graph showing winners (out-performers) and losers (under-performers). The sample includes funds at the beginning of the 10-year period, ending in December 2010. The graph shows the proportion of funds that outperformed and under-performed their respective benchmarks (i.e., winners and losers) during the initial periods. Winning funds were re-evaluated in the subsequent period from 2011 through 2015, with the graph showing the proportion of out-performance and under-performance among past winners. (Fund counts and percentages may not correspond due to rounding.) Past performance is no guarantee of future results. See Data appendix for more information. US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago. 


Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.



The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.