September 8, 2016

Survivorship Bias Explained

Long Term Capital Management is a perfect example of how hubris can derail even the most brilliant of investors. The hedge fund was filled with PhDs and Nobel Laureates, but was highly leveraged while relying far too heavily on quantitative risk models that didn’t factor in the potential for unexpected events to occur. When Russia defaulted on their debt in the late-1990s, LTCM was toast, requiring a bailout from the Fed and losing nearly all of their investor capital in the process.

Not only is LTCM a lesson in the dangers of overconfidence in the markets, but the way their demise was handled in the hedge fund index world is also instructive on the prevalence of survivorship bias in financial data.

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This is a perfect example of the problem with survivorship bias in reported performance numbers. If you only focus on the winners and don’t pay attention to the losers your entire frame of reference can be thrown off and the data you’re trying to assess can lead to false conclusions. Mutual fund companies are guilty of this as well. They promote the funds that are performing well lately and don’t mention or even shutter the funds that are performing poorly.

Read complete article at http://awealthofcommonsense.com/2016/09/survivorship-bias-explained/

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