My latest at Yahoo, on Survivorship Bias:
“If you had bought Praj Industries at Rs. 2 in 2003 for just 100,000 rupees, it would be worth Rs. 40 lakh today!”
We hear something like this, as advisors and brokers coo about the long term greatness of the stock market. If you bought Infosys in their IPO in 1993, you would make a gazillion rupees, so much that you would be reading this article in your holiday home in the Bahamas. Yet, in the early 90s , IT stocks weren’t the darling of the markets – more popular was a stock called Arvind Mills, which still exists and has done fairly well for itself; but if you had plonked your hard earned money into Arvind, you would have seen a stock going from Rs. 400 down to a relatively meager Rs. 43 today, only 18 years later. And that was still lucky; a number of other stocks simply went to zero.
What happened? We counted the winners. If you count only the survivors, no accident has casualties.
While survivorship bias is a classic problem with benefit of hindsight, it teaches us important lessons – that what is visible isn’t everything and that it’s critical to diversify. For a person investing equally in a number of stocks from stock market darlings to pariahs, the losses on one set of stocks could have been made up by gains in others; remember that you can’t lose more than 100%, but you can make many multiples of your investment when you win (“multi-baggers”). If you research stocks well, chances are you will have a few multi-baggers and losers – sometimes many more losers, but the winners more than make up for the losses. The winners become the survivors and investors become geniuses for discovering them; the real genius though was the diversification.
A simple rule in the trading world is to cut your losses and let your winners run. That’s counter-intuitive; many investors believe the exact opposite – that they would book profits when a stock gains a certain amount, say 10%. But should the stock fall, they will wait till they get out at “break-even”, even if that takes an enormous amount of time. The problem here is that you limit your gains, and set yourself up for much higher losses – which over a longer term will lose money, even if this strategy works like a charm in markets that go up. When it doesn’t work, everyone else is losing money, so one doesn’t feel quite as bad. And here, survivorship bias works again -because people who win on this strategy will brag about it, but someone that lost money will probably have sworn off stocks forever.
When you cut your losses, you end up with remorse when the stock recovers from your selling price to a new high. You’re accused of disloyalty, of deserting a company when it is in a spot of trouble, of not holding on. While there is some truth in that assertion, it’s just as likely that either the company was overvalued or that the prices reflect information you don’t yet know – but the loyalty argument wins because you never count those stocks that didn’t recover after you sold them.
Imagine you get a letter saying “The Sensex will go up this week”. And it does. Another letter arrives the following week saying, “This week, the Sensex will fall”. And remarkably, the index does fall. A few weeks of incredibly accurate information then ensues, and after six weeks you are told that further information will no longer be free; you have to pay Rs. 100,000 to get access to the “proprietary black box system”. Well worth the money, you think. You pay, and find the system highly inaccurate in subsequent weeks. What happened?
The modus-operandi was to first gather 10,000 addresses of potential suckers, and to send 5,000 of them a letter saying the Sensex would go up, and the remaining a letter saying it would go down. If the Sensex did go up, they ignored the latter, and divided the “winning” 5,000 people into two to run the mails again. After six weeks, they had 150 people for whom they were incredibly accurate; and who are most likely to pay up. A good 2/3rd of this group might pay, not aware of this scam. The tricksters make a Rs. 1 crore killing from this group through a system that is about as scientific as a coin flip, and all for the cost of some postage. All the scamsters had to ensure was that they chose people who didn’t talk to each other!
Survivor bias also impacts our views of what makes people successful. “Work hard, and believe in yourself”, they say, “look at Narayana Murthy“. But what of the millions that worked hard, but didn’t make it?
“Warren Buffett is a great investor, you should buy and hold forever, like he does”
“The best business is the restaurant business. See, every restaurant today makes money.”
All of the above is valid but again, not all who live by those precepts have become successful. At some point, luck and fortune play a part, a much greater part perhaps than skill itself. Warren Buffett himself attributes some of his success to luck.
My wealth has come from a combination of living in America, some lucky genes, and compound interest. Both my children and I won what I call the ovarian lottery. (For starters, the odds against my 1930 birth taking place in the U.S. were at least 30 to 1. My being male and white also removed huge obstacles that a majority of Americans then faced.)
My luck was accentuated by my living in a market system that sometimes produces distorted results, though overall it serves our country well. I’ve worked in an economy that rewards someone who saves the lives of others on a battlefield with a medal, rewards a great teacher with thank-you notes from parents, but rewards those who can detect the mispricing of securities with sums reaching into the billions. In short, fate’s distribution of long straws is wildly capricious.
(This was when he said he would donate more than 90% of his weath over the rest of his life. That is one feature I unabashedly admire. I just hope I’ll be rich enough that 90% of my wealth will be a useful donation.)
Warren Buffett may have bought and held forever, but there are a vast number of successful traders who haven’t, and still made enormous amounts of money. Many of them, like Michael Burry, chose to slip out of the public limelight despite their ludicrously successful careers. I would have never even heard of Burry, were it not for Michael Lewis’ “The Big Short”; I wonder how many more exist that lived to not tell.
More Yahoo Columns:
