Considering Survivorship Bias in Investing

Dr. Abraham Wald was a Hungarian mathematician who contributed to many fields, but is most noted for founding the field of statistical sequential analysis.  His researching years were spent at Columbia University.

During World War II, the Center for Naval Analyses conducted a study of the damage done to aircraft that returned from missions.  This was a time when bombing losses were severe, and unsustainable.  They recommended that extra armour and reinforcement be added to the areas that showed the most damage.

Dr. Wald, however, noted that the study only considered the aircraft that had survived their missions.  All the bombers that had been shot down were not part of the damage assessment.  This means that the returning aircraft were the ones that survived being shot at.  The damage  were in areas the bombers could take damage and still return.  It was the areas that were not full of holes that should be reinforced.

The following picture is a stark illustration of survivorship bias.

This blind spot applies in many areas of our lives.  In business and investing, this can be seen in otherwise great books about investing, which analyse why certain companies have become so successful.  They do not consider why a larger number of businesses have failed.  This means these studies and reports highlight some areas, but leave out the full picture.  This heavily impacts our investment strategy.  This is why investors lose money in otherwise favourable circumstances.

Survivorship bias is especially acute in the small fund end of the market, when it comes to impact funding.  The focus of the analysis skewed towards the success stories, but fails to account for all the other businesses in that same space that failed.  This makes it less like a science, and more like a lottery.  By considering the companies that failed, we get a better picture of the environment, and are better placed to advise accordingly, and address issues before they become fatal.