If you only bet on winners, you will lose

If you look at investment funds, they have all performed well over the last few years. If you mix a few of them into a portfolio, you should get handsome returns overall. However, all investors who have done this in the past have a gut feeling that they have not done such a good job. There is a difference between expectations and results. Why is that?

Good examples are dangerous

Perhaps because they have oriented themselves too much towards positive examples. Like the engineers who worked for the Royal Air Force during the Second World War. Their bombers flew missions across the Channel almost daily, many planes never came back, presumably shot down. The engineers decided to improve the armoring of the planes. To prevent the planes from becoming too heavy overall, they had to decide on a few places. So they took a close look at the planes after the missions, counted and measured all the bullet holes. And then armored right there. Without success. The kill rate remained the same.

Then the mathematician Abraham Wald came along and turned the thinking on its head. His recommendation: "Armor the planes where they have no bullet holes. Because the bullet holes we see are not fatal. The planes will come back. Only the bullet holes that we don't see afterwards are fatal." This thinking finally helped.

The British engineers were not alone, they thought as almost all people think. For our decisions, we like to follow examples that have turned out well. Since the Second World War, statisticians have called this thinking error survivorship bias: our brain favors the survivors. (And it forgets those who were unlucky).

Our brain only sees the survivors

Could this be the reason our investments are not performing as we expected?

Investment funds don't live indefinitely, either. Year after year, funds go out of business. Occasionally because they perform really badly and have to be closed. Mostly, however, it is because they perform so moderately for so long that customers run away from them. Most banks and other asset managers regularly close funds with less than 100 million dollars invested in them – they cannot be run profitably enough.

If you want to select a fund, you only see the survivors. That makes sense. Why would a provider present you with funds that no longer exist?

However, ignoring the funds that have closed in recent years is a costly deception. In his 1995 study, Burton Malkiel was the first to precisely quantify how costly. He collected prices from all equity funds that were licensed in the USA between 1971 and 1991. That was a total of 239 funds. He then compared: a portfolio of all funds – and a portfolio of only those funds that survived at least ten of the twenty years.

The portfolio with all funds achieved a return of 15.69 percent. (Admittedly, from today's perspective, this is a figure we can all only dream of). The portfolio containing only survivors, on the other hand, returned 17.09 percent. In retrospect, the survivorship bias results in a gap of 1.40 percent.

There is no question that we would all have preferred to have invested in the second portfolio. But could you have predicted which funds would survive?

Invisible bullet holes give investors 1.4 percent less return. If you don't think about this in advance because of survivorship bias, you will be disappointed by exactly this amount. This is not an exciting realization. But at least you now know that you need to scale back your expectations.

Turn your thinking on its head

The solution is simple. And it sounds almost as paradoxical as Abraham Wald's suggestion to tank the invisible holes. It is: don't make any predictions. Passive investing is the motto. You simply bet on everything and don't even try to predict what will and won't work.

Today, there is an alternative to active investment funds. With ETFs, you can bet on almost any index in the world. During Malkiel's study, the broad American share index S&P 500 increased by 17.52 percent per year – almost two percent more than the portfolio with all funds.

Links

• Burton G. Malkiel: Returns from Investing in Equity Mutual Funds 1971 to 1991 (Link hinter Paywall)