Survivorship Bias May Be Tricking You Into Taking Too Many Investing Risks

No matter how well a trader does in the market, they can always find traders online than have done even better. But the better a trader has done in achieving huge gains, the more dangerous it may be to follow his or her recommendations.

Investors suffer from a long list of psychological biases that can adversely impact their success in the market. One of the most dangerous biases for investors is a phenomenon known as survivorship bias.

What Is Survivorship Bias? Survivorship bias is the tendency for people to cherry-pick people or strategies that successfully made it through a selection process and ignore all those that failed. People tend to focus on these survivors, even if they survived in large part due to luck rather than viability.

Survivorship bias comes into play when a person starts with a success story, whether it be a successful entrepreneur, a world-champion athlete or a billionaire stock investor, and attempts to reverse-engineer a personal pathway to similar success. The presumption is if I do exactly what this billionaire investor or entrepreneur did, I will be a success just like he or she was.

In reality, the most successful outliers on Wall Street over any given short-term period almost always took some extreme amount of risk that just happened to pay off big. But just because a particular strategy worked one time for one person doesn’t mean it’s a good strategy for others.

Related Link: 5 Cognitive Biases That Are Killing Your Investment Returns

If a man bets $100,000 on the number 19 on a roulette wheel and the number hits, he will win $3.5 million. But only one out of every 37 people who attempt that strategy will “survive” and get the big payout. Sure, the strategy worked for the guy that won. But does that make the strategy smart or viable? Of course not.

Historically, the SPDR S&P 500 ETF Trust SPY generates an average annual return in the range of 8% to 15%. But in any given year, there are plenty of traders who generate returns that are 10 times higher than the market.

It’s extremely unlikely that someone who has an investing strategy that generates a significantly higher return than the S&P 500 has found a strategy that is safe and consistent. More than likely, that trader has simply “survived” a very dangerous approach to investing simply by getting lucky.

Exploiting Survivorship Bias: Scammers have even taken advantage of survivorship bias by using simple probability to convince people that they're skilled stock pickers.

On any given day, a person can email 10,000 different people a single microcap stock pick for that day along with a guarantee it will gain at least 10% during the following week. If the scammer picks 10,000 different stocks and only one out of every 25 of them gain 10% that week, it means 400 people received accurate predictions.

If the scammer repeats the process the next week by sending another 400 picks to those remaining 400 people, it means 16 people would receive two different stock picks that each gained at least 10% in back-to-back weeks.

The scammer can then follow up with a message claiming that if these 16 people just pay $1,000 each for a stock-picking newsletter subscription, they can be rich in no time. In reality, they would simply be paying $1,000 each for totally random microcap stock picks.

“I think survivorship bias really colors how we look at the world, because it leads us to look at these highly selected events and then make inferences and say, ‘Oh, that manager and that person must be good,’” Sendhil Mullainathan, a professor of computation and behavioral science at the University of Chicago Booth School of Business, once said.

Instead of identifying true stock-picking talent, we are often simply identifying the small percentage of traders that took a dangerous approach to the market and ended up getting lucky. Meanwhile, we ignore the vast majority of people who took a similar approach and failed.

Survivorship Bias And Risk: The S&P 500 is on track to finish 2020 up 16.8%. In reality, any investor who will finish this year with gains of 16.8% or higher had a great year and should feel good about their performance.

However, plenty of people who put all their eggs into trendy investments like Tesla Inc TSLA, the Grayscale Bitcoin Trust GBTC or Zoom Video Communications Inc ZM and others likely far exceeded that 16.8% return this year. But those traders are simply the survivors of an approach to investing that didn’t work out so well for the majority of investors who picked just a handful of stocks back in December 2019.

If you're always chasing the gains of the most successful stock pickers, you will be exposing your portfolio to unnecessary risk due to survivorship bias. Instead of focusing on the latest trendy stock picking outliers, a safer strategy is to look at investing and trading techniques that have worked consistently for a wide variety of traders for decade after decade.