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Survivorship Bias and the Evolution Paradox in Investing
Sometimes it takes an example from outside your professional context to give you perspective on how strange things are within your chosen industry. On a recent episode of Compounders, Greg Dean, the lead investor at Langdon Equity Partners, contrasted the way technology companies invest in new people and products with how investment firms add new people and strategies. The idea was that if an Apple engineer identified a product niche that could tap into a $1 billion TAM, the company would never tell that person to first get to $100 million in revenue before investing in people or R&D. No product would ever get built under that framework. And, in that scenario, the engineers would quickly recognize that they were unlikely to be successful operating with no resources and promptly give up.
But that's exactly how the investment industry approaches incubating new strategies. PMs are often expected to run the strategy on the side, sometimes covering an entire universe by themselves, and to try to attract investors only after three years of outperformance. Then, only after getting to ~$100 million in AUM (at least in the long-only world) are resources available—people and a research budget—to supplement the PM's efforts. In essence, technology companies invest to grow, while many investment firms only backfill once a strategy has proven to be successful. This comparison is clearly a generalization. Not every technology firm operates that way and certain investment firms are willing to invest to grow, even if it depresses margins in the short run. But what Greg's example reveals are the somewhat hidden elements that can either doom a new strategy or give it a shot at scaling. With that in mind, there are two essential but under-discussed concepts that are always at play within the investment industry: survivorship bias and investor evolution.
Let's start with the former. Survivorship bias can be simply defined as a process that recognizes the winners but ignores or doesn’t properly consider the losers. To me, being exposed to survivorship is like taking the red pill from The Matrix. Everywhere I look in my life, I see how people, especially those of us who live in the US, valorize and normalize wealth and professional success while ignoring those that failed in trying to achieve the same goals. Maybe 1,000 people tried the same thing and failed miserably because the process was completely flawed—yet all you see is the one person who succeeded. You never hear the stories about the other 999 people because the media doesn't cover them, and they probably pursued an alternate career.
You most definitely see it in professional sports. The existence of Lebron James suggests that anyone can become one of the greatest basketball players of all time. However, it doesn't mean the chances of doing so justify the effort. How many people dedicate their lives trying to be the next Lebron or MJ to no avail? The reality is that we only see a tiny fraction of people who play basketball seriously and make it to the NBA. Ignoring the plight, struggles, and lives of those who failed is the definition of survivorship bias.
Within the business context, many of us habitually study successful people and try to reverse engineer their paths. We look at their traits or even flaws and hope that we can replicate their success by being more like them. In doing so, we risk learning the wrong lessons. For example, Steve Jobs was known to be a jerk yet is absolutely revered as a visionary. I am sure some people view his success as legitimizing his demeanor—or even making it desirable. In Silicon Valley speak, being a jerk is seen as a feature, not a bug. Survivorship bias allows such myths to perpetuate. Did being a jerk contribute to his success as a leader or was Steve simply so talented he survived and thrived despite that? Furthermore, maybe he was extremely lucky as well. Was being so hard on other people part of a good process that led a great outcome? I doubt it. Not to take anything away from Steve’s achievements, but luck can help lead to good outcomes, irrespective of process, just as bad luck can derail a good process. What you want to understand is the processes of successful people. However, in most cases, all you see is the outcome. The problem with that is you can’t know the counterfactual or observe the success rate of all the people who tried the same thing. Maybe Steve Jobs would have been an even more prolific creator if he had been easier to work with. And maybe most people who are that demanding and abrasive either flame out or must change their tactics to avoid absolute failure. Only the uber-talented jerks survive long enough to be immortalized.
Survivorship bias is ubiquitous in the investing world. For instance, mutual fund returns databases are often plagued by the fact that the funds that disappeared are no longer in the data set. So, you end up with skewed performance metrics that are tied only to the survivors. Even within the survivors, knowing what portion of generating market-beating returns stems from luck, skill, or circumstance is impossible. Many potentially great investors got unlucky during their first shot at being a PM and are no longer in the game. On the other hand, plenty of people may have been wholly unprepared for the task but were simply lucky during the first few years. Then, they developed both the proper traits and surrounded themselves with enough good people to build a holistic skillset. We hear and internalize the stories of the survivors—but not those who didn’t make it. My point is that the people you see who have been doing it for 20-plus years are the survivors. They have the associated scars. They have also grown and evolved substantially as an investor over time, whether they are keen to admit it or not. Evolution is required to survive.
The distinctly unglamorous process of incubating a new strategy
To dive deeper into the topic of evolution, let's start with a hypothetical situation. You are a 30-something-year-old analyst sitting with your PM in a very large, well-known asset manager's office in Boston. Unexpectedly, they mention that they are looking for a manager to fill a need in a strategy adjacent to your firm's core strategy. They then ask if your firm would be interested in seeding a new strategy to fill that demand. You look at your PM and, in unison, say, "sure!" And that is how the idea of a new strategy is born.
A seasoned investor once gave me the 3-question test for whether to start a new investment strategy:
Is it adjacent to what you already do?
Can you manage the strategy competently?
Does anyone outside of your firm care that you started this new endeavor?
In the above scenario, #3 was satisfied, and in all honesty and practicality, any rational team would figure out how to take a swing, irrespective of what the members truly believed. For an investing purist, the idea that a firm would start a strategy based solely on external demand, even if the team was unsure about (or even uncomfortable with) the answers to #1 and #2 above, might be off-putting. I appreciate that. But public investment people operate in a highly competitive industry where returns can go from looking solid to nearly awful in a matter of quarters—and what seemed to be a scaled, super profitable strategy can become sub-scale and over-resourced in the blink of an eye. That is the nature of not having locked up money. The private equity guys understood that from the beginning and, as a result, have created a better business model. The illusion of stability—the idea that levered equities don't go down when the S&P 500 craters—is a beautiful marriage between the allocator (who doesn't want to explain to an investment committee why a strategy lost money) and the manager (who has no interest in marking down an asset because of the lost fees and the hit to performance) that is not going to end anytime soon. I digress, but the point is that if you haven't figured out how to lock investors' money up for seven years, you will sacrifice purity to maintain or grow assets.
Back to the story about the new strategy. Not every strategy starts this way, but a lot of the process will sound familiar to people who have been through it. The first stage is infancy, where the strategy is very nascent and unformed, and a new portfolio manager is like a baby trying to figure out the world. Concepts like portfolio construction, position sizing, timing of entry or exit, and adding/trimming are not typically part of the analyst program's curriculum. So, you learn on the fly and make many mistakes, hopefully, before you have outside clients' money. This is what I call the "paper portfolio" stage, where there is no live money or a small amount of the firm's capital in the strategy. No matter who you are or what someone will tell you after the fact, this early stage is marked by frequent uncertainty and imposter syndrome. You have your hands on the wheel, but you aren’t 100% sure anyone should have actually allowed you to drive the car.
No stats are available regarding how many strategies make it out of infancy, but the survivorship rate is likely somewhat low. When you combine the unpolished skillset of new managers with the fact that they are likely tremendously under-resourced and bandwidth constrained, the strategy is unequivocally set up to fail. However, I’d argue that is a perfectly acceptable scenario from everyone's perspective. The prospect of the strategy growing into something meaningful is a low-cost option for the manager and the firm. If it works, especially if a strategy can scale, the upside can be life-changing for everyone. And if it doesn't work—for any number of reasons that may have nothing to do with the abilities of the PM—the strategy dies on the vine, most clients never know about it, and the PM goes back to being an analyst, armed with some new skills that were developed in the process of trying to manage a strategy. The analyst improves and evolves, often with limited damage, aside from the opportunity cost of the time spent on the new strategy instead of on the firm's core offerings. A good way to fail for everyone involved is doing it fast and in the dark.
A logical question would be, what distinguishes the strategies that eventually attract capital from those that perish during infancy? There is likely no precise formula. For example, a successful investor who manages a few billion dollars recently told me over lunch that the smartest thing he did was start three strategies at once: small, SMID, and microcap. People told him that the only way to do that effectively would be to have a lot of overlap in terms of stocks within the three strategies. He thought that was a terrible idea. His rationale was that if you own some of the same stocks and they underperform, they tank all three strategies' performance. So, he created three independent strategies and ran them simultaneously—and it has worked. After 20 years of running these three strategies, it’s clear that he is an exceptional investor. He has found the style of investing that worked for him and has stuck with it. Plus, in the beginning, he found a way to survive via diversification and then was able to become—or evolve into—a very talented investor. One lesson for anyone starting a new strategy is to do anything and everything to not get knocked out of the game.
What I am trying to illustrate throughout is that people are not born into being a great investor; they evolve into being one through an amorphous, hard to predict process. Investing is a Darwinian game in its purest form. Most strategies die in their infancy, and those that survive are under constant threat. Over the long run, only the lucky and skilled investors stay and thrive. In his piece, The Playing Field, Graham Duncan discusses the evolution of an investor much more eloquently than I can. My contribution is to shed light on the fact that what we see from the outside is only a small fraction of the underlying reality regarding what it takes to build a new strategy and improve as an investor. All we see are the survivors. The key point is that both allocators and young investors should be careful about lionizing other investors or trying to replicate their success by taking a similar path. It is unreasonable to believe that being lucky and landing in the right circumstance can be reproduced consistently. Plus, what works for one investor temperamentally or process-wise might not work for others. Instead, we should recognize success for what it truly is: an indication of the ability to survive. Calling someone a survivor is not a denigration of their abilities. It is the ultimate compliment and recognizes an inevitable evolutionary journey as an investor.
Only the evolved survive
The following is a thought experiment that highlights the paradox of evolution in investing. An allocator walks into an established firm's office to hear about a new strategy that has been incubated and is seeking initial investors. The PM is in her mid-30s, and this is her first time managing a strategy. Assuming the previously mentioned factors surrounding survivorship are at play, the base case is that this strategy has at least survived the typical pitfalls that occur in infancy. Further, if her experience is like mine—in becoming a PM at 36—at that stage, she only knows a small fraction of what she needs to know about security selection, portfolio construction, learning from mistakes, and risk management that she will know when she is 41. And even then, assuming she survives as a decision-maker, she will only be partway through the lifetime journey to becoming an exceptional investor.
In giving her money to manage today, the allocator is likely not thinking about the required evolution. The person making that decision is looking at her NOW and trying to decipher if this person is a skilled investor who can outperform over a reasonable time horizon. My premise is that aside from in the case of some very rare outliers—the Lebron Jameses of investors—the base case should be that she is not great yet at 36. Yet the allocator writes a check as if that were the case. Herein lies the paradox. It is the pink elephant in the room that no one addresses. Allocators ask about process and collaboration and current best ideas. However, they don’t ask the question they should want to know the answer to: how would you assess your current skillset and what do you need to improve over time?
Even if that question was posed, the manager would almost be expected to answer the way people respond to the question, what is your biggest weakness? I work too hard. I am too detailed-oriented. I am too passionate about investing. "Of course, I am already a skilled investor at 36 and I will only get even better." How else should someone respond when the prospect of securing outside capital is so close? Most analysts dream of being a PM who runs a meaningful amount of capital. As a result, you fake it until you make it. The image of a young investor who is "often wrong, never in doubt" is not simply a stereotype. It is a necessary reality. No one will invest with you unless you are confident. Maybe allocators will shy away from overtly arrogant 30-somethings, but confidence is a must, even if is a façade or based on false premises and insufficient experience. (As an aside, in investing parlance, “experience” is also known as losing a lot of money on a stock you were so excited about you went on a podcast extolling its virtues.)
Figure out who is going to be a survivor
In closing, the takeaways from this long exploration are that:
The business of investment management is not particularly glamorous (true for the majority of investors)
Luck is probably as important as skill in investing, especially during the early years (definitely true)
Most new PMs are not as skilled or confident as most allocators believe or would likely want (mostly true)
The key to success is simply surviving (don't argue with evolution)
A skeptic might argue that, if all the above is true, an allocator should wait and see before giving money to a new PM. Why not see who the survivors are and wait for their skills to become a little more refined? I can't argue with the logic of being patient. But my view is that an allocator evaluating a new PM should be looking not for superior skill but for adaptability and the ability to learn from mistakes—for someone who can evolve, regardless of age. Most allocators don't want to hear a manager say, "When you hired me 5 years ago, I had no idea what I was doing. But thanks anyway for supporting me. It was your support that has allowed me to grow so much." To me, the only reason that statement could conceivably be painful or cringeworthy is if you expected polish before it was likely to be there. If you were looking for malleability and consistent improvement, you should be thrilled to hear such a progress report after the first 5 years. In that case, the proper response from the allocator would be, "I hope you say the same thing about this moment 5 years from now."
I once penned a quarterly letter detailing my evolution, my mistakes, and how my investing philosophy had changed over time. The letter was never published. (Maybe it is finally time to post it). The feedback I got was that it was well-written, but "our clients don't give a sh*t about your evolution." Indeed. They hired me to outperform even though I was still trying to figure out the investing style that fit with my temperament and risk tolerance. Having said that, I am grateful for the experience of running millions of dollars of clients' assets because it taught me what I must do to be one of the survivors. I am still evolving and adapting, and I hope to be able to say that when I am Munger’s age (99).
In writing this, I hope that sharing some of my experiences provides other investors with license to open up about their own evolution. Just because a lot of people won’t touch the subject, doesn’t mean it isn’t critically important. With the launch of this new Substack, my goal is to cover many of what I perceive to be unspoken investment truths. I hope you will stay tuned.
Stay curious and open-minded,