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Backtesting, Survivorship Bias, Silent Evidence

Summary

Survive. As in from death.

Many losing Mutual Funds are closed and merged into other funds to hide poor performance.

When backtesting with an index, Survivorship bias is the use of a current index member companies rather than using the actual constituent member companies changes over time.

In his book The Black Swan, financial writer Nassim Taleb called the data obscured by survivorship bias "silent evidence."

"In a study performed in 1987 it was reported that cats who fall from less than six stories, and are still alive, have greater injuries than cats who fall from higher than six stories. Cats that die in falls are less likely to be brought to a veterinarian than injured cats, and thus many of the cats killed in falls from higher buildings are not reported in studies of the subject."

"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 a 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, which 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 and applying entry and exit dates to gain the appropriate return during inclusion in the index would allow for a bias-free output."

"A commonly held opinion in many populations is that machinery, equipment, and goods manufactured in previous generations often is better built and lasts longer than similar contemporary items. (This perception is reflected in the common expression "They don't make 'em [them] like they used to"). Again, because of the selective pressures of time and use, it is inevitable that only those items which were built to last will have survived into the present day. "

"Just as new buildings are being built every day and older structures are constantly torn down, the story of most civil and urban architecture involves a process of constant renewal, renovation, and revolution. Only the most (subjectively, but popularly determined) beautiful, most useful, and most structurally sound buildings survive from one generation to the next. This creates another selection effect where the ugliest and weakest buildings of history have long been eradicated from existence and thus the public view, and so it leaves the visible impression, seemingly correct but factually flawed, that all buildings in the past were both more beautiful and better built."

"Whether it be movie stars, or athletes, or musicians, or CEOs of multibillion-dollar corporations who dropped out of school, popular media often tells the story of the determined individual who pursues their dreams and beats the odds. "

- Source [Wiki]

Very interesting read.