Question

1. Briefly explain how the “survivorship bias” of the COMPUSTAT database can explain the book-to-market effect where stocks with high book-to-market ratios tend to have significantly higher returns than stocks with low book-to-market ratios.

Answer 1

Survivorship bias is the bias that occurs when the performance of existing stocks in the market are taken to be representative of all the stocks without considering stocks which have gone bankrupt are not considered. Doing this, has the effect of overstating the average return as only high-performing stocks are considered. This is the issue with the COMPUSTAT stock database which does not include stocks that have been delisted. This has the effect of significantly overstating the average return as successful stocks (high book to market ratio) with high returns are taken to represent the entire market without considering the return for unsuccessful stocks (low book to market ratio).