Survivorship Bias - in Finance

In Finance

In finance, survivorship bias is the tendency for failed companies to be excluded from performance studies because they no longer exist. It often causes the results of studies to skew higher because only companies which were successful enough to survive until the end of the period are included.

For example, a mutual fund company's selection of funds today will include only those that are successful now. Many losing funds are closed and merged into other funds to hide poor performance. In theory, 90% of extant funds could truthfully claim to have performance in the first quartile of their peers if the peer group includes funds that have closed.

In 1996 Elton, Gruber, & Blake showed that survivorship bias is larger in the small-fund sector than in large mutual funds (presumably because small funds have a high probability of folding). They estimate the size of the bias across the U.S. mutual fund industry as 0.9% per annum, where the bias is defined and measured as:

"Bias is defined as average a for surviving funds minus average for all funds"

(Where is the risk-adjusted return over the S&P 500. This is the standard measure of mutual fund out-performance).

Additionally, in quantitative backtesting of market performance or other characteristics, survivorship bias is the use of a current index membership set rather than using the actual constituent changes over time. Consider a backtest to 1990 to find the average performance (total return) of S&P 500 members who have paid dividends within the previous year. To use the current 500 members only and create an historical equity line of the total return of the companies that met the criteria, would be adding survivorship bias to the results. S&P maintains an index of healthy companies, removing companies that no longer meet their criteria as a representative of the large-cap U.S. stock market. Companies that had healthy growth on their way to inclusion in the S&P 500, would be counted as if they were in the index during that growth period, when they were not. Instead there may have been another company in the index that was losing market capitalization and was destined for the S&P 600 Small-cap Index, that was later removed and would not be counted in the results. Using the actual membership of the index, applying entry and exit dates to gain the appropriate return during inclusion in the index, would allow for a bias-free output.