A Good Joke Is Worth A Thousand Words

Monday, August 24th, 2009

Dilbert

I thought this was a good addition to the blog. Even though it is a joke, it’s also is a great example of the survivorship bias on Wall Street.

Investopedia explains survivorship bias as, “The tendency for mutual funds with poor performance to be dropped by mutual fund companies, generally because of poor results or low asset accumulation. This phenomenon, which is widespread in the fund industry, results in an overestimation of the past returns of mutual funds.” This means that a mutual fund company’s selection of funds today “will include only those that have been successful in the past. Many losing funds are closed and merged into other funds to hide poor performance. This is an important issue to take into account when analyzing past performance.”

I’ll say. If a family of funds is only showing you their winners, it’s not hard to see where investors might be misled into thinking that they have good performance.

This is also true of indexes, trading systems, CTA’s etc. Take the Dow Jones Averages as an example.

According to The Motley Fool, the Dow came to life in 1896, priced at 40.94. The original companies were American Cotton Oil, American Sugar, American Tobacco, Chicago Gas, Distilling & Cattle Feeding, General Electric, Laclede Gas, National Lead, North American, Tennessee Coal & Iron, U.S. Leather pfd., and U.S. Rubber.

Today, only General Electric remains in the Dow.

So, is the rise from 40.94 to somewhere around 9500 the performance of these companies? I don’t think so, although it is a good strategy. Eliminate your losers and your track record will drastically improve.

Clients should judge managers on all funds that they have managed since they started their companies and not just existing funds. This is also true of indexes, trading systems or searching for a CTA. It is routine to see trading systems revised, or a different version released. You see CTA’s launch several programs and then confirm to the public how good they have done with the surviving successful one.

FOOD FOR THOUGHT: Since the average stock fund has trailed the Standard & Poor’s 500-stock index benchmark over the years, imagine what it would look like if all the “deceased funds” were counted in the numbers.