Beware of Survivorship Bias When Investing
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today is episode 421. It's titled, Beware of Survivorship Bias When Investing.

I have an earthquake insurance policy that is up for renewal. I bought it via Policy Genius about a year ago. It's for our home in Tucson. And as I saw the premium, I was tempted not to renew the policy.

After all, there has not been an earthquake in Tucson since at least 1931. I changed my mind, though, after finding some data that suggested that even though there hasn't been an earthquake, the probability of an earthquake with a magnitude greater than 5 is close to 20% over the next 50 years. And when I compare the cost...

of the premium, the annual premium is only 0.05% of my house.

Now, I'm not completely rational when it comes to earthquake insurance because we don't have earthquake insurance on our cabin in Idaho. In Idaho, there's a 73% chance of an earthquake greater than 5.0 in the next 50 years. But I've rationalized that decision by saying, well, it's just a cabin. Our home in Tucson is made out of adobe brick. Cabin is a log cabin, mostly. Seems like it's more stable.

And most of the value or more of the value in that property is in the land rather than the structure itself. Having said that, I probably should get earthquake insurance on the cabin in Idaho also.

Because there hasn't been an earthquake in Tucson since at least 1931, it is tempting to conclude there will never be one, so I shouldn't purchase earthquake insurance. This is an example of survivorship bias. Survivorship bias is the tendency to focus on successful examples to draw conclusions about the world, to ignore the failures and just focus on what has been successful. A famous example is Darius

During World War II, U.S. military looked at the damaged aircraft that came back to the bases and decided to put armor, additional armor, on the areas that had been hit by ammunition. Abraham Wald of Columbia University said that was the wrong conclusion. Instead, more armor should be added to the areas that were least hit because those were the areas that when they were hit, the airplanes crashed and didn't return.

Another example of survivorship bias is the long-term average performance of U.S. stock mutual funds overstates their success because in many cases, the long-term average doesn't include funds that closed because they underperformed or they failed so they were shut down. There was another example of survivorship bias in an academic paper I read this week. The strong performance of the U.S. stock market relative to other countries

could be an example of survivorship bias. The paper is titled, Is the United States a Lucky Survivor? The authors of the paper constructed a comprehensive database of 55 countries with the returns from 1920-1920.

to 2020. Back in 1920, most countries didn't have developed stock markets. Even the U.S. was in a terribly developed market, and as a result, the markets were fairly similar. And it was not easy to determine which country would have the best performance over the next 100 years. For example, Argentina was one of the 10 richest countries in the world. It

Its economy was growing faster than Canada and Australia. But as we saw in episode 409, Argentina has had military coups in 1930, 1943, 55, 62, 66, and 76. Argentina has defaulted on its government debt nine times. It's had extended periods of

of hyperinflation. All those events led to underperformance of the Argentina stock market. I actually had a difficult time finding the long-term performance of the stock market and finally found one paper that estimated the returns from 1899 to 2021 were about 3% annualized. That's a nominal return. On a real basis, it was negative 3%. Now let's compare our

Argentina with the U.S. The U.S. has had no war fought on the mainland since 1920. The U.S. did have the Cuban Missile Crisis, but that was resolved peacefully. There's been no coups. There's no hyperinflation. The authors then of this paper believe the U.S. stock market has had higher returns because investors priced in the risk of crashes, potential wars, economic upheavals,

disasters, but because the U.S. hasn't had one, there's been positive surprises that have led to higher returns. There's been more consistent dividends over time. Dividends haven't had to be cut because of war or other economic disasters.

There obviously has been the Great Depression, the Great Financial Crisis, but not the type of long-term decimating war-type crisis with a coup or something along those lines.

Then the author suggested over a longer time period where there hasn't been a major crisis, investors became more confident that a crisis wouldn't occur, that there was a survivorship bias. We're observing a lack of crisis in the U.S., assuming there won't be one, become more confident there won't be one. And as a result, stocks got more expensive and that higher valuation led to higher returns. Another paper published

read was by Ivo Welch, who's an economist and professor of finance at UCLA. The paper is titled, The Time-Varying Importance of Disaster Risk. Welch asked, what can we learn from a long history in which we have never seen an event, event being some type of disaster or crash? He says, what we can learn is that such events are infrequent.

but they are not impossible.

In his paper, he looked at the cost of protecting against stock market losses greater than 15% using put options to protect. And one of the interesting charts in the paper was the average annual cost of protecting against a 15% greater loss in the U.S. stock market ranged from about a half a percent per year to over 7% per year. So it varied depending on the level of fear by investors.

But through that analysis, looking at the pricing of options, Welch concluded that the probability that a 100-year financial market disaster could have occurred but didn't. There was a 37% chance the U.S. could have had an 80% or greater stock market crash, but it didn't. Welch writes, our concern is not that there were a few unsampled dark realizations or events in the

in the center of the population distribution. In other words, so it wasn't the concern, wasn't that the events were missed, that they were there, but we didn't see them. Rather, he continues, our concern is that there were a few high magnitude left tail realizations, black swans, that happened not to have been observed yet.

Because it didn't happen yet. That's why on the podcast, we teach protect against the downside. We measure risk, not by volatility, but how would our lifestyle be impacted by a 60% crash in the stock market, 70%. Referring back to Argentina, back in 2019, Argentina saw a 45% decline in their stock market in one day.

We should consider how our human capital can be used, our ability to earn income can be used to offset a major loss. We've had some discussions on Money for the Rest of Us Plus recently with recent retirees that mentioned that their fear of making an investment mistake is much greater now because they don't have the ability to gain back those losses through employment income.

Another paper then that focused on survivorship bias is a paper on safe withdrawal rates using the 4% rule. This paper came to my attention because one of our PLUS members mentioned a YouTube video by Canadian investment advisor Ben Felix that also looked at this paper.

The 4% rule we last looked at back in episode 326. It was developed by Bill Bengen, who published a piece in 1994, where he looked at what is the safe withdrawal rate from a defined contribution plan or from an investment portfolio, where you have the first year withdrawal rate

And then the next year, you increase that dollar amount by the rate of inflation. So if it's a $1 million portfolio, using the 4% rule, that first year distribution would be $40,000. And then the next year, it would increase by the rate of inflation. He felt a 4% was what he called a safe max, the maximum that you could spend without the risk of running out of money.

He updated the study in 2020, and we discussed that in episode 326. He determined that the withdrawal rate, the safe withdrawal rate, would have been 4.5%, looking at portfolios going back to 1926. He assumed a 30-year time horizon, and the portfolios were invested 50% in stocks, 50% in bonds. Using under that analysis, 30 years, 50-50 portfolio, there were times investors could have

have withdrawn 13% in the first year of retirement and then adjusted it for inflation. The average that they could have spent out of their portfolio was 7% in the first year and then adjusted upward by inflation.

The worst case, protect against, was 4.5%. He said it's not a law of nature, this spending rule. It's empirical. It's based on certain conditions and assumptions. 30-year time horizons, 50% U.S. stocks, 50% bonds.

This academic paper then looked at this same type of study, a 4% rule. But instead of using the U.S. market or other markets, it did something called bootstrapping.

They constructed a database of asset class returns of 2,500 years of data from 38 developed countries going from 1890 to 2019. And then they randomly selected returns from that database and constructed 35.

30-year time horizons, but it was data from all over the world. And they adjusted the data to maintain consistency with how stocks and bonds typically perform together and how other asset classes do. Now, before we get to the conclusions of that, let me share some other introductory comments they made in that paper regarding this 4% rule, how ubiquitous it is.

It's recommended by financial advisors. They point out mutual funds, brokerage companies. There was a paper by Choi that looked at the 50 most popular personal finance books and found that 12 provided specific advice to use the 4% rule and four had rates even higher, 5% to 8%. The 4% rule has appeared in testimonies in front of Congress and it's on a number of stories

state and federal government websites as a method for safely withdrawing from retirement funds. Before we continue, let me pause and share some words from this week's sponsors. Before we continue, let me pause and share some words from one of this week's sponsors, NetSuite.

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A survey by Vanguard found that 22% of participants in the financial independence retire early movement, FIRE movement, plan on using the 4% rule. The authors say the 4% rule is a leading example of the divergence between finance theory and practice.

What finance professors say that investors should do is not follow the 4% rule. They recommend using an annuity, a safety-first approach to get guaranteed income, something that we've talked about numerous times on the podcast and something that I plan on doing with a portion of my retirement assets, getting a media annuity so that I can get a guaranteed income source. And one of the reasons I am going to do that is papers...

like the one we're going to discuss. What's interesting is investors are less likely to use an annuity now than they were 20 years ago.

There was a paper that looked at TIAA, which is the Teachers Insurance and Annuity Association. It's the primary savings program, retirement program for educational institutions, universities. The authors of this paper looked from 2000 to 2018 and found that participants were less likely to choose annuities over time. Part of it is TIAA offered other ways to take distributions.

distributions to actually get a cash distribution or to get a regular distribution from the retirement plan, but it was an annuity. Less than 50% of participants selected an annuity. This was from a retirement organization that started and whose whole foundation was annuities.

But it's not something people are comfortable doing because they don't like giving up control of their money. They want to hold some of the funds for their beneficiaries. Maybe they don't understand annuities quite as well, but it's that loss of control. But finance theories suggest that's the best approach. And it can be complemented with investing, but most investors don't do that.

Let's go back then to this paper. They pulled then and they constructed portfolios, 60% stocks, 40% bonds, looked at and they based their study on a 65-year-old couple and then looked at the probability of financial ruin, running out of money, and found that with a 4% rule, retired couples faced a 17% probability of

of running out of money, of depleting their retirement assets using the 4% rule. Again, they didn't just pull from U.S. data, they pulled from all over the world. One of the things they pointed out is even though we have 120 years of U.S. stock market data, that's really only around four 30-year periods. And maybe the U.S. suffers from survivorship bias. Nothing bad happened here that led to long-term underperformance.

They pointed out in Japan that the nominal return of the Japanese stock market from 1990 to 2019, a 30-year period, was negative 9%, nominal negative 21% on a real basis. So it's certainly the 4% rule would not have worked had you retired in Japan in 1990 and didn't have a pension and were invested in the Japanese stock market for your equity component.

A retired couple faces a 17% probability of financial ruin using the 4% rule based on their study. Then they wanted to figure out, well, how much could they spend? What's the safe max? And they found it to be 0.8% if they wanted to keep the probability of ruin at 1%. Can you imagine that? $8,000 from a million-dollar portfolio. To reduce the probability of financial

financial ruin to 1%, which just isn't realistic, obviously. So then they looked at, well, what would the spending rate, the initial spending rate have to be for a 5% probability of ruin? And in that case, the safe withdrawal rate was 2.3%.

They looked at different allocations. Maybe if we are more aggressive than 60-40 or less aggressive, they found other allocations didn't really improve the outcomes. Still very high probability of ruin using the 4% rule. They looked at target date funds where the equity allocation is reduced over time. That didn't help either.

What do we do then? Well, we can use an annuity to help fund retirement. The other thing, and Ben Felix points this out in his video, is we don't have to sit there and continue to spend until we run out of money. We have the ability to adjust how much we pull from our retirement based on market performance. We can defer Social Security in order to get a higher benefit from that, which

serves as essentially an inflation indexed annuity. We can increase our spending by less than the rate of inflation in order to have our assets last longer. So the takeaway is, yeah, if we use a different data set than just the U.S., use the world, use some type of bootstrapping analysis like these papers do. And in fact, we referred to a similar type bootstrapping analysis back in epigenetics

episode 250 on avoiding financial ruin. And again, in that episode, looked at the spending rates.

One of the things that we shouldn't be is catastrophist. We can't assume that because the U.S. hasn't had a financial disaster that completely destroyed the stock market, that it will soon. It's a possibility. On the other hand, we shouldn't assume that it will never happen. Be a techno-optimist. That was a term used by Vaclav Smil in his book, How the World Really Works.

He pointed out some things regarding scale. The U.S. is much larger now than it was. It's economy more diverse and as a result, potentially more able to withstand shocks. Smil refers to the inertia of large complex systems and that that is due to its basic energy

energy and material demands. We don't change, for example, how much steel that we need on an annual basis or how much cement or how much energy is being used. He pointed out that renewable energy, the supply, has risen 50-fold in the last 20 years. Yet the world's dependent on

on fossil fuels only went from 87% to 85%. The world annually uses 4 billion tons of cement, 2 billion tons of steel. And our ability to transition away from how that's made would be incredibly slow.

In other words, there are elements, there are physical limits, constraints to how the world works that contributes to the longevity of economies. The idea that economies grow because of productivity improvements over time. Very slow productivity improvements. Economies grow because of population growth, which is slowing but still growing. That economic growth leads to growth in corporate earnings.

Companies pay a share of those profits in the form of dividends. And if you look over time, dividend yields have been fairly static in the U.S. and around the world. We get that cash flow to help fund our retirement.

Our takeaway then is the U.S. has benefited from survivorship bias. Returns have been higher than the rest of the world because the U.S. has avoided some of the catastrophes and crashes that have impacted the rest of the world.

If the U.S. experiences one or more of those type of crashes, that could have a detrimental impact on performance. But that doesn't mean that the U.S. is destined to have one. Because of the size and scale of the U.S., that its ability to withstand that type of crisis is greater than a smaller nation. As savers, as retirees, then we need to decide.

Are we all in on the U.S.? Or do we want, as financial academics suggest, a broader portfolio, own the market portfolio, a global stock market that has stocks from over 40 countries? So we're not completely dependent on the U.S., which has done very, very well.

Or do we want to be less dependent on the stock market overall by constructing a retirement using some type of guaranteed income source, such as an annuity, so that we're not completely dependent on the stock market?

Those are the decisions that we need to make. I prefer a global stock portfolio. I prefer to use annuities. We'll see, though, when the time comes. I can say that now. Let's see if I pull the trigger someday when I actually retire. That's episode 421. Thanks for listening.

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