4-Minute Read
Do you want to read something entertaining and insightful but don’t have much time? Short stories and parables can provide both enjoyment and valuable lessons about human nature.
Although financial lessons are not typically found in parables, I came across one called the Baltimore Stockbroker that I’d like to share with you.
In this piece, we’ll see how the parable has practical implications in the real world. We will also try to extract some useful takeaways for you as an investor.
The Parable
Jordan Ellenberg, in his illuminating book, How Not to Be Wrong – The Power of Mathematical Thinking, shares a powerful story that we’ll look at from two perspectives.
One – Your Perspective
Imagine receiving a newsletter from a stockbroker in Baltimore. The newsletter predicts that a certain stock is going to rise, and a week later, it does. The following week, the newsletter predicts that the price of another stock is going to fall, and sure enough, it does.
This pattern continues for ten weeks, with each prediction coming true. Eventually, you receive a solicitation from the stockbroker to invest money with him. Although there is a hefty commission, it seems like a good deal since the broker has been so accurate with his predictions.
The math may match your intuition. If we assume that each stock pick had a 50/50 chance of being correct, the odds of the stockbroker being so consistently successful are extremely low – in fact, it would be a 1 in 1,024 chance of hitting that kind of string of success.
This must be a demonstration of pure skill, or is it?
Two – The Stockbroker’s Perspective
From the perspective of the stockbroker, the story looks different. In the first week, the newsletter was sent to 10,240 people, half of whom received a prediction that the stock would rise (including you) and the other half received a prediction of a fall.
In the next week, the newsletter was only sent to 5,120 people, which included those who received a correct prediction of a rise. Those who received the opposite prediction were not contacted again.
This pattern continued, with the number of recipients decreasing each week for those who received correct predictions in a row. After ten weeks, only a “lucky” few, including you, received ten straight winning picks.
Of course, it is advisable to steer clear of this stockbroker. His only apparent skill seems to be manipulating people. But I suppose you can appreciate his patience and mathematical insight. While situations like this may not exist in the real world to the same extreme, companies can still employ similar tactics to deceive investors.
A Brief Look at Survivorship Bias
Ellenberg goes on to describe a common practice in the financial industry. A company can be preparing to launch a mutual fund to the public. They might maintain the fund in-house for some time before making it publicly available. This practice is called incubation.
What happens behind the scenes is that the company incubates many funds at once. This gives the company the chance to experiment with different strategies and asset allocations.
Many funds will not survive this incubation period. That’s not unexpected or undesirable. It’s having the one or few funds that have outsized returns that matters. Those can be packaged and marketed to the public. The trouble is that funds that survive the incubation process may be no more likely to outperform once public.
This all comes down to the concept of survivorship bias. This is a cognitive bias that occurs when we focus on the things that have survived a particular event or process while ignoring those that have not. This bias can distort our understanding of reality and lead us to make incorrect assumptions or decisions.
Put more simply, for some investment strategies, survivorship bias overstates good performance and understates bad outcomes.
Lessons from the Parable
Let’s end with three lessons you can take away from this parable as an investor.
One – Beware of Incorrect Inferences
Realize you can draw incorrect conclusions from data that is completely true. When evaluating fund managers, it’s important to consider their entire set of funds, even those that are no longer available for investment. This is because a track record that appears impressive may actually be incomplete and biased if only a selective set of funds is considered.
I’ll briefly expand on this. You may have come across the terms “passively managed” and “actively managed” investment strategies. While I cannot claim that one is superior to the other, I would like to point out that passive strategies are more likely to be free from survivorship bias.
Passive investment strategies aim to closely follow a specific benchmark. The goal of the fund manager is to minimize any deviations from the benchmark, also known as “tracking error.” This approach typically results in lower internal costs for managing the fund. When comparing two passive fund managers, you can examine how each fund has performed relative to the benchmark over time.
Active strategies require more analysis and scrutiny. Survivorship bias is just one of the potential reasons. Understanding if the higher costs are worth paying is another.
Two – Don’t be Blinded by Past Performance
Look at more than just past performance when evaluating a fund manager. Don’t get me wrong. Performance is important. As the parable shows, we just don’t want to be misled by it. Focus on the foundational principles of investing.
What else should you look for? Consider the manager’s investment philosophy, the strength of their strategy design, and their ability to efficiently manage their portfolio and trades. These qualities are essential for providing a positive investment experience and helping you reach your financial goals.
Three – Apply these Lessons Beyond Your Portfolio
Try to recognize survivorship bias in the business world. It’s easy to get into discussions about successful entrepreneurs. Sometimes they are exuberant people who get extra attention in both financial and social media. You might even want to mimic someone you know who has found success in a certain field.
Just remember that there are probably many others who have tried and failed. Give just as much, if not more, focus on those who didn’t make it. It can help you better understand the risk of the venture you’re seeking and help you avoid crucial mistakes.
If you have comments or questions on this piece, please drop me a line at: [email protected]
References
- https://www.amazon.com/How-Not-Be-Wrong-Mathematical/dp/0143127535
- https://www.dimensional.com/us-en/insights/why-worry-about-survivorship-bias
- https://krishnawealth.com/three-foundational-principles-of-investing/
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