Posted by: jhamon | June 1, 2009

The “Survivorship” Problem

June 1 (Bloomberg) — General Motors Corp. and Citigroup Inc. were removed from the Dow Jones Industrial Average, replaced by Cisco Systems Inc. and Travelers Cos., after the first global recession in 70 years crippled their earnings and sent their shares down more than 90 percent.

This points up one of the illusions of indexes: the Dow Jones 30 Industrials Index doesn’t really represent anything other than a selection strategy implemented by Dow Jones.  Stocks lose 90% or go out of business, but the illusive index justs grinds on – with nothing but the survivors left in it. (Remember Worldcom?  Enron?  Lehman?)  The survivorship bias doesn’t represent a global conspiracy to conceal the truth; it’s just a reality of the economy that businesses come and go.

However, when it comes to developing and validating trading strategies, it is essential to understand and correct for the survivorship bias.  Think about it for a second: If you go and try out your shiny new value investing model on data that doesn’t include the above and many other late greats, you are introducing a tremendous distortion into your results, because your simulation doesn’t include even the possibility of being long a Lehman on the day of its sudden bankruptcy.  For this reason, we always incorporate a complete set of all U.S. stocks, including defuncts and delisteds, into our work.  The old saw still stands: GIGO = Garbage In, Garbage Out.

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