Why long-term U.S. stock market outperformance could be because it has avoided major catastrophes. Does an over-reliance on historical U.S. stock returns when modeling retirement outcomes lead to spending rates that are too high?
Topics covered include:
- Why you might consider earthquake insurance
- What is survivorship bias and what are some examples
- Why the U.S. is an outlier when it comes to stock market performance
- Why the 4% retirement spending rule might be too high
- If the 4% spending rule is too high, what can retirees do instead to have enough for retirement
- Why the size and scale of the U.S. economy provide some resistance to catastrophes
Show Notes
Survivorship Bias—Matt Rickard
The Financial History of Emerging Markets: New Indices by Bryan Taylor—SSRN
The (Time-Varying) Importance of Disaster Risk by Ivo Welch—Financial Analyst Journal
The 2.7% Rule for Retirement Spending by Ben Felix—YouTube
Trends in Retirement and Retirement Income Choices by Tiaa Participants: 2000–2018 by Jeffrey R. Brown, Et al.—SSRN
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Transcript
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’s episode, 421. It’s titled, “Beware of Survivorship Bias When Investing.”
Earthquake Insurance
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 five 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. It’s a log cabin mostly; it 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
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 during World War II the US 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 the 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 US 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 US 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 to 2020. Back in 1920, most countries didn’t have developed stock markets. Even the US 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.
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