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20/20 Spectrum

Investing is a balance between pattern recognition and open-mindedness. Studying great businesses and finding commonalities is a great way to build your mental database of pattern recognition, but there is one downside – survivorship bias.

Survivorship bias is basically an exercise in cherry-picking. We focus all of our effort on the companies and leaders that were successful and in the meantime, we forget about the ones that failed. It’s focusing on Facebook and ignoring the MySpace’s.

It’s tricky though. Isn’t the whole point of studying the Facebook’s to understand what they did what right and what the MySpace’s did wrong? Then applying those frameworks to other companies so you can identify which ones will succeed and which ones will fail?

Before getting into it, let’s back up one step.

I think we can agree there are certain principles that, when embraced, lead to more success than others. Things like focusing on customers, long-term thinking, innovating, adaptability, strong sense of purpose, servant leadership, and so-on. And there are certain things, when followed, that are destructive. Things like short-term maximization, workplace politics, micro-management, lack of purpose, bottom-line-is-king syndrome, and so-forth.

These are exercises in pattern recognition. Studying the best businesses of all time will likely lead you to some similar findings. But then the natural, next question is: to what degree did the MySpace’s embrace the Facebook principles? In other words, are we blinded by survivorship bias?

I would like to direct your attention to this 2x2 matrix (who doesn’t love a good one of these?) below. On the y-axis are the inputs, the principles that led to a company’s success or failure, and the x-axis reveals the binary outcomes – success or failure.



We understand the pattern recognizers, those make sense to us. But the bad luck and good luck squares, don’t quite make sense, so we oftentimes chalk it up to luck. Or for instance, in the good luck square, where destructive principles end up working out, we say things like “nice guys finish last, in business you have to be cutthroat.” Or in the bad luck square, it sounds more like “well, you know the statistics about the failure rate of businesses.”

Here’s the thing. The world is incredibly complex. It doesn’t fit in nice, neat 2x2 matrices. Frameworks are helpful, but sometimes they limit our open-mindedness. I’m not saying that there aren’t certain principles that increase a businesses’ chances for success; there are. But, we haven’t even added in the layer of timing. In the 2x2, it’s a very binary, backward-looking evaluation. Good input = good output. But in investing, successful companies can begin to fail and then succeed again and then fail and then, yep you guessed it, succeed. Management teams can be swapped in and out, new product lines can be launched and shut down, company culture can be renewed and destroyed.

If I would’ve told you on November 7, 2008 that Domino’s Pizza would have been a 100-bagger over the next 12 years, there’s no way in heck that you would’ve believed me. But, with hindsight, it’s very easy to conjure up a simple, “good inputs” story. Closed down company-owned stores, changed the recipe, invested in technology, boom a 100-bagger. So now, all we have to do as investors, is watch out for a failing franchisor with a new turnaround plan that matches Domino’s to a tee. With our pattern recognition skills, it would be a cinch, right? Well, maybe and maybe not.

Once again, I’m not saying that pattern recognition doesn’t have value. In fact, I believe the opposite. I don’t think you can be a truly great investor without it. But, it’s not the only thing. An over-reliance on it can lead us to think we have all the answers because we know all the patterns. And this can lead to lazy thinking. Because once we see the pattern, our brain shuts off since we’ve already "figured out" the problem.

This is a hindsight problem. Looking back, with the luxury of knowing how things turned out, it’s so easy to fool ourselves into thinking we would’ve known all along. But when we look forward, that confidence dies down. That’s why keeping a stock journal is so important. Often we are right, but for the wrong reasons. With that said, I think people can err too much on the side of survivorship bias. Just because we don’t account for all the similar examples who failed, doesn’t mean we can’t learn anything from the successful companies.



I’m personally on the left side of this spectrum. I think studying the greats is a very worthwhile exercise. The same goes for failed companies. It’s important to understand the variables or commonalities so that when you see it again, you can have an advantage.

However, it’s easy to only believe in pattern recognition. Sometimes it can limit our open-mindedness. In those cases, remembering survivorship bias can help.


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