While many enjoy blasting market timing, very few admit passive investors face high risks. In fact, Monte Carlo simulations show that passive investors in S&P 500 face 50% drawdown with 50% chance. For small caps investors this risk increases to about 60%.
Passive investing would be in trouble had central bankers not decided to directly intervene in equity markets after the financial crisis. Passive investing is a scheme where an investor and a fund management firm both profit without doing anything related to market timing. This induces moral hazard as more investors want large returns by going passive and more fund managers realize large fees while not taking any forecasting risks. If markets fall, they can always blame the economy and the government but not themselves. A more serious side effect of passive investing is that both good and bad companies are rewarded by passive investors and that creates economic excesses that must be painfully removed at some point in time.
As the passive investing trade gets crowded, risks increase. The more people that park their money waiting for returns, the larger the market drop will be next time there is an unpredictable event, as most of these investors usually pick bottoms to get out instead of tops. Few passive investors have the discipline of staying invested along corrections and much fewer engage in bargain hunting near bottoms. Most investors want to get out when a sharp decline occurs in fear of losing everything.
Below is a buy and hold chart of S&P 500 since 1960. The benefits of the two long uptrends in the 1990s and in last 10 years are counterbalanced by two large drawdown levels due to dot com crash and financial crisis.
This chart is even uglier than it looks. A Monte Carlo simulation based on equity curve changes in the daily timeframe generated the following cumulative distribution of maximum drawdown.
There is 50% probability (loosely speaking) that the drawdown will be larger than 45%. There is probability of about 15% for a drawdown of 60% or larger. This is not an easy ride as seeing a passive investment in S&P 500 losing half of its value is a coin toss based on past history and assuming it is a guide for the future.
In small caps, currently on a strong uptrend, the situation is a little worse.
In this market there is 60% probability of a 50% or larger drawdown, worse than fair coin toss. For a 60% or larger drawdown the probability is about 25%.
Obviously, Monte Carlo simulations have certain limitations, at times serious. In this application of Monte Carlo analysis the most serious drawback is that the results are conditioned on past data. Regime changes could affect the results but it is not very likely that they will improve substantially. If the current uptrend continues for 10 more years, then this is a possibility but if a bear market follows that will possibly reinforce the current state of the results or even increase probability of large losses.
Another question is the timeframe of the results: If the probability of 45% or larger drawdown is 50%, over what holding period does this apply? Obviously, the probability of a 50% drawdown in one day is extremely low. The answer here is that the longer the holding period, the higher the chances that the Monte Carlo results apply. The results were obtained for a holding period of about 59 years in the case of the S&P 500. Monte Carlo simulations occur in ensemble domain (averages) but drawdown levels occur in time domain (returns) and this makes direct estimates of holding periods difficult.
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