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Writer's pictureF W
Mar 267 min read

Realistic Stock Trading Expectations (Survivorship Bias)

Don't be fooled by the data


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VIDEO TRANSCRIPT BELOW:-


Hi all, In this video we discuss one of the most important biases that newbies encounter in the stock market -  Survivorship bias.


Many new traders often take up stock trading after looking at past performers, especially those that have gained 1000’s of percent, whilst imagining the potential riches that await them. However, there is a significant flaw to this trail of thought. Past data hides or omits much more than it shows in stock trading as it constantly sheds failures and over-emphasizes winners.


Decisions made using such skewed data often leads to unfavorable outcomes. Which is why the success rate in trading is so low. Nine out of ten traders fail to succeed at trading, and among the ones who do succeed, or generate positive returns, there are only a small number who make most of the gains. It’s similar to the riches across the globe, where the richest 1% own more than two thirds of all available wealth.


As a new trader or investor, you must aspire to be in that small percentage of successful traders, and for that, you need to enter with the right expectations. This is where understanding survivorship bias helps.


One of the most famous examples of survivorship bias can be explained in the analysis of Allied military aircraft that returned from combat missions during World War II.  A study of returning planes showed that many had taken heavy damage to the wings, the tail, and the center of the body. The military initially planned to add armor to those areas to prevent damage; however, Columbian University mathematician Abraham Wald, who was hired to assist with the study, noted that this approach was flawed because the military only considered those planes that survived combat and returned. In essence, military analysts were only focusing on parts of the plane where damage was not fatal during the mission.


If the aircraft was reinforced in the most hit areas, this would be a result of survivorship bias because crucial data from fatally damaged planes (which never returned) was being ignored. Those hit in other places did not survive. Therefore, Wald recommended, that the military add armor to the portions of the returning aircraft that bore the ‘least’ damage.


Let’s look at a simple real-world example to better understand survivorship bias.


We all love the favorite search engine; Google, which has a massive 85% market share in online search. Seeing Google and the profits it has made over the years is awe inspiring. However, if we go back in time to the late 1990s there were many prospective Googles. Most of them however disappeared after the dot com crash.


As a current investor, we would look at Google and imagine the fortune that would have been gained had we invested in early. However, what we fail to factor in is the probability of picking Google among the many other search engines that seemed to be doing better or as well as Google at that time.



Most who invested in the now-defunct search engines assumed that they would create huge wealth for themselves. There was no way for them to find out who the real winner would be back then.


A great example of survivorship bias can also be demonstrated through the 2023 US Investing championship. I took part in the competition finishing 32nd out of around 400 entrants with a net 27% return and reasonable risk management. The winner netted in excess of 800% with others not too far behind. Observing traders will look at those results in hope of gaining huge riches with the bar of expectation set very high. What this set of results does not show is the non-surviving participants, perhaps those that used significant risk and lost everything. The final results presented to the world only show the outperformers, it does not show the risk taken to achieve such results and it does not show all the accounts that lost everything, this epitomizes survivorship bias.


In retrospect, this entire phenomenon looks crystal clear. The survivor tells a good story that leads to a very optimistic belief for the future. This is what survivorship bias does. It paints a picture rosier than it is, which makes investors or traders take undue risk and expose themselves to the risk of ruin because of their overly optimistic beliefs.


The mere knowledge of the bias can go a long way to ensure that an investor takes a more cautious approach in the beginning.


The key point here is that you need to emphasize equally on the failures of the past as much as you do with the winners. An emphasis on the failures of the past helps in protecting your downside. With that knowledge, you can bolster your systems and processes to ensure that the failures of the future don’t make you leave the arena.


Let’s now understand what bolstering your system means.


An overly optimistic approach in trading can leave you puzzled and shattered once the losses start showing up in your positions. A good trader knows that there will be plenty of losses in trading. However, a newbie who has come in for profits on the back of previous winners, gets severely disheartened when their positions start showing losses.


At some point, ego overpowers the psychology of a trader, and they end up holding onto losers allowing them to make a huge dent on capital. Many times it’s too late, and the trader throws in the towel. Once that is done, the trader becomes too fearful to trade. Afterward, when the missed trades start performing, the trader jumps back into FOMO mode, which makes them lose further capital because the entry to the trade is poor. With significantly depleted capital and mental exhaustion, the trader leaves trading forever. All this can be avoided if the trader understands that losses are a part of the game, and this isn’t anything new or unexpected.


For those interested I’ll leave a link at the end of the video touching more on trading expectations.


Once you’re aware of survivorship bias and it’s implications to your trading analysis and expectation, all you have to do is ensure that the ever occurring non-survivors don’t bite you too hard. For this, you would need a cohesive exit strategy when a trade goes against you. In my group, I preach using stop losses that aren’t too strict but also not too loose. A stop loss too strict will not allow for general market volatility, and a stop loss too loose will put a large unaffordable dent in your capital. Again, we have a great video showing a study on the most optimum stop loss percentage vs a buy and hold approach, I highly recommend clicking the video link at the end of this video….


Amongst the many exit strategies, a simple indicator like the 20-week moving average can save you from the risk of ruin if followed diligently. I often use this indicator in combination with others to exit my shorter-term trades.


For example, here is a chart of Canopy Growth Corporation - symbol WEED. The stock made a great bottoming pattern and started its up move when it was making higher highs and higher lows. It then gave a consolidation breakout at 378 and ran up close to an 85% gain to 703. The price then quickly reversed and failed to bounce. It then closed below the 20-week moving average here at 400 and never moved above it for several weeks. The stock is now trading at a 99% percent loss from the point It closed below the 20-week moving average.


Here is another chart of Tattooed Chef Inc., a stock picked by Jeremy Lefebvre of the Financial Education channel. After tripling in six months, the stock whip sawed around the 20-week moving average before starting its disastrous decline from $19 to less than a cent today.

 

Here is another calamity pick from Jeremy - Planet 13 Holdings. This stock also saw a precipitous decline after it closed below the 20-week moving average at around $7.5 down to $0.75 - a disastrous 90% plus decline.

 

Here is a stock from Cathy Woods stable - Personalis. After it closed below the 20-week moving average it dropped from over $30 to $1.6. And another called Berkeley Lights Inc. The stock doesn’t trade anymore and the last It traded was near one dollar. The stock touched a high of $113 before its 99% decline. Had the investor simply followed the 20-week moving average, an exit would have been possible at $80, which would have saved significant money for the investor.

 

If you had asked Jeremy and Cathy about the stocks at the time when they were starting their decline, they would have told you that the stock would make a fortune, perhaps even advising to buy more. Now this is a big problem due to small investors having less capital, therby concentrating their bets too much. Such concentration may lead to a significant loss of capital if the investor falls into the trap, assuming that these people knew exactly what they were doing, whilst hanging on to the hope of being involved in the next Google.

 

This is what survivorship bias does to an investor's thinking. They think of every bet as the next Tesla or Google irrespective of what the data suggests. It would be helpful if you entered the trading arena with the right expectations. You must know that not all stocks can be held forever, and you need to have a plan for the bets that go against you.

 

The 20-week moving average is only one tool amongst many others that can take you out of a declining stock. Other Indicators such as the MAC-Dee or Dow Theory can also be used. The key is to have at least one.

 

More than the indicator, you need to build a psychology that ensures you have the right unbiased analysis, the right expectation, without getting emotionally attached to any one stock.

 

With the right expectation and a realistic probability of success, you can avoid survivorship bias and be in the plane that consistently returns to base.

 

As always thanks for watching, and I hope these videos help you build the right foundation to make your trading a long-lasting endeavor. Please do consider hitting the like button to see similar videos, and why not join our fantastic community of traders where you gain access to my strategy and screening software to beat the market. Bye for now


For those interested, we have a highly engaged group that uses our bespoke breakout scanner to find some of the best trades, offering low-risk high reward potential. Feel free to use the links below, and as always thanks for watching.



My Brokerage Account (Interactive Brokers) - https://bit.ly/3UGvn1U

My Breakout Scanner - https://bit.ly/3ea6sl8


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