Survivorship Bias in Mutual Fund Reports


Mutual funds remain one of the most important investment vehicles for the middle class. Mutual funds compete intensely for investors. They often tout superior past performance as proof that they will continue to yield a good return. How reliable, however, are reports of past performance? The SEC closely regulates how mutual funds’ managers calculate and describe past returns, so these reports are factually accurate; but performance reports can, however, be both accurate and misleading. Mutual fund performance reports can be skewed by survivorship bias. To understand survivorship bias, consider the following fraudulent scheme used to cheat sports bettors:

First, find the mailing addresses of 1,600 people who place heavy bets on sports. Write to each of them and say that you will predict the outcome of three football games. Then, for $100, you will sell them your prediction for who will win the Super Bowl. If your prediction on the Super Bowl proves incorrect, you will refund their money. For the first game, you should send to 800 people a letter predicting that one team will win, and to the other 800, a letter predicting that the other team will be victorious. Next, forget about the people to whom you made the false prediction. For the 800 people for whom you correctly picked the outcome, send half of them a letter claiming that one team will win the next game, and send the other half a letter claiming the opposite team will win. After the second game you will now have 400 people to whom you have correctly predicted the outcome of two games. You repeat the same process for these 400 people. At the end of the third game you now have 200 people to whom you have correctly predicted the outcome of three football games. You mail each of these 200 people a letter saying that you will correctly predict the outcome of the Super Bowl for $100. You also promise to return their money if you incorrectly predict the outcome. For the people who send you the $100, you tell half of them that one team will win and the second half that the other team will be victorious. You then return the money to the people for whom you incorrectly predicted the Super Bowl outcome. Assuming that all 200 people paid you for your super bowl prediction you have now made a profit of $10,000 minus postal costs. Furthermore, all the people whose money you have kept are satisfied since they got what they paid for.

Now, imagine that instead of playing this game with sports bettors, you play it with investors. You start with a large number of mutual funds. They all make different investments. You close down the ones that do badly and keep the ones that do well. You only advertise the funds that do well, saying they have a successful track record and thus you must be good at investing.

The managers of mutual funds don’t exactly play this game. Poorly performing mutual funds, however, are often closed down, making the ones that are kept operating seem better than they really are. For example, imagine that this year 100 new mutual funds are started. Further imagine that each fund manager makes his investment decisions by throwing darts at a newspaper listing of stocks. After a year the funds that do poorly are closed down. On average, the surviving funds’ performances will be well above average. This doesn’t mean that these funds’ managers have any skill at picking investments, but rather that survivorship bias makes past performance misleadingly attractive.




Game Theory at Work(c) How to Use Game Theory to Outthink and Outmaneuver Your Competition
Game Theory at Work(c) How to Use Game Theory to Outthink and Outmaneuver Your Competition
ISBN: N/A
EAN: N/A
Year: 2005
Pages: 260

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