Morningstar - Q3 2020 - 34

Strategies

Accounting For Survivorship
Data on a unique market in an
unparalleled time is inherently biased.
		Research

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With Structured Notes, It's Buyer Beware
Sustainable Funds Weather Downturns
Better Than Peers

		

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Solving the Asset-Location Problem, Part I
Best Ideas

Manager: Staying Power
Passive: Low Costs Seal the Deal	
Equity: A High Bar

RESEARCH

Paul D. Kaplan and Laurence B. Siegel

The U.S. equity market has had a phenomenal
run. Since the end of 1870, a dollar invested
in a capitalization-weighted market portfolio
would have grown to over $18,000 by the
end of May 2020 in real (inflation-adjusted) terms.
That's a compound real return of 6.8% per
year. This happened despite 18 market declines
of more than 20% each in real terms.
Each decline was followed by a recovery, and
after recovering, the market went on to
new heights.1

Not only does the U.S. have a unique capital
market history relative to other countries, but the
period over which we measure the capital
markets is unique in human history. According to
economist Deirdre McCloskey and others,2 there
was essentially no economic progress for most of
human history until a little over 200 years ago
(more on this later). The past two centuries are the
period over which we measure equity market
returns, because that is the only period for which
data are available. So, we are measuring what
happened in a unique market over a unique
period in history, a practice that compounds two
separate sources of bias.

As we will discuss, the United States had
several things going for it that allowed it to attain
such impressive market results, as did a
few much smaller countries. Other countries
were not as lucky. In 1900, Germany, Japan,
the United Kingdom, and Argentina all had good
prospects, as did some other countries.
However, being on the losing side of a world
war or two, the overthrowing of capitalism,
or just prolonged poor market performance would
have wiped out the capital of investors. In
the cases of Germany, Russia, and Japan, most
investors would have outright lost their
claims to their capital.

In this article, we discuss some of the unique
history of the United States that led to
its resilient equity performance and dominant
place in world capital markets today. We will
then look at the return and volatility of the equity
markets of a number of countries and try to
explain why these differ across countries.
In doing so, we not only demonstrate the existence
of survivorship bias but also offer some
explanation as to why the bias exists. We will
then discuss the unique period of economic
development for which we have stock market
data, adding another dimension to the
understanding of the biases in the historical
market performance data that we rely on.

Therefore, when analyzing historical performance
data on U.S. markets, or other unusually
successful markets, and drawing conclusions from
those data, our findings may be distorted by
survivorship bias.

Incomplete Coverage of the Opportunity Set
Survivorship bias is a potential problem
whenever one uses past data to make forecasts.
For example, a forecast of the equity risk
premium-based only on that achieved in

1 See Kaplan, P.D. 2020. "Black Turkeys Everywhere." Morningstar magazine, Q2, PP. 37-41.
2 McCloskey, D.N. 2006. The Bourgeois Virtues: Ethics for an Age of Commerce (Chicago: University of Chicago Press).

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