Introduction

As pointed out in our previous article, inconsistency in returns because of outlier moves along with increasing volatility makes it difficult for most investors to mechanically execute their strategy and stay in the game. With the coronavirus crisis, passive investing strategies got whipsawed because of surging volatility. The current situation puts many passive investors at risk of achieving returns inferior to their expectations. In this article, we'd like to dig deeper into the impact of market timing and how randomness annihilates passive investing returns. We also present solutions in the next article as to how we can create more consistency in our returns.

Study: MSCI USA Equal-Weighted Equities Buy-and-Hold Performance

Setting up the backtesting

In the study that we've recently conducted, we focus on nine consecutive years of a particular strategy but entered at various dates. In this case, we're going to examine the buy-and-hold performance on the MSCI USA Equal-Weighted ETF excluding dividends. Before diving into some incredible statistics, I'd like to explain what the trade series represent (always on the first day of the month, or as close as possible).

• Trade series 1: buy-and-hold performance from June 2010 to June 2019.

• Trade series 2: buy-and-hold performance from July 2010 to July 2019.

• Trade series 3: buy-and-hold performance from August 2010 to August 2019.

• Trade series 4: buy-and-hold performance from September 2010 to September 2019.

• Trade series 5: buy-and-hold performance from October 2010 to October 2019.

• Trade series 6: buy-and-hold performance from November 2010 to November 2019.

• Trade series 7: buy-and-hold performance from December 2010 to December 2019.

• Trade series 8: buy-and-hold performance from January 2011 to January 2020.

• Trade series 9: buy-and-hold performance from February 2011 to February 2020.

• Trade series 10: buy-and-hold performance from March 2011 to March 2020.

• Trade series 11: buy-and-hold performance from April 2011 to April 2020.

• Trade series 12: buy-and-hold performance from May 2011 to May 2020.

Annual returns

As you can see from the graph below, the last two trade series take the coronavirus crash and subsequent (partial) rebound into account. We want to intentionally show our readers the effects of a drawdown on your returns, which is particularly interesting for investors near retirement. Deciding at which time you start withdrawing funds from your IRA, 401k... will lead to various outcomes that are subject to the stock market's volatility at that point in time, i.e., the coronavirus crash.

(Source: Option Generator Research)

As one can see from the graph below, a difference of 3/6/12 months between two purchases has an enormous impact on the forward 1-year returns. That shouldn't surprise us at all. But what about the cumulative performance?

(Source: Option Generator Research)

Cumulative performance

As for the ending portfolio value, starting at a hypothetical $100, the impact of a one-time drawdown or series of multiple corrections starts coming into play. For example, a typical person (50th percentile) who has been investing for 5 years would have made $70 on his initial investment. Just looking at the average is not a good representation of the data as the minimum gain stands at $42, whereas the maximum profit after 5 years equals to $103...

(Source: Option Generator Research)

Of course, the trades weren't entered on the exact same date (the maximum difference is 11 months as mentioned at the beginning of this segment) but it highlights the huge amount of variation caused by corrections and thus volatility. It's these extremes that cause investors to eventually quit and take funds out of their account at the worst possible moments. Even the difference between the 25th and 75th percentile can be as large as 20%. Bringing in the compound effect and potentially poor forward returns, you'll recognize the sizable portion of luck or randomness that's involved when investing passively without a strategic approach.

(Source: Option Generator Research)

Drawdown analysis

Assuming your goal is to generate an annualized return of 10%, the coronavirus drawdown has had a devastating impact on the passive investing strategy. Now, that doesn't automatically mean you'll end up losing money in the long run (hopefully not); it just highlights that you now need a 19.50% annualized return to reach your initial goal set by year 14! I would say let your imagination run wild and decide whether that's a realistic target... Don't forget that the EUSA represents a basket of stocks and that current valuations might be a little stretched.

(Source: Option Generator Research)

Simulating different scenarios

To demonstrate the impact of poor market timing, let's pick the worst, 25th percentile, median and 75th percentile returns. Same story: a lot of fluctuations. First and foremost, believing in smoothing the risk out by spreading your capital over many months simply doesn't work if volatility kicks in.

(Source: Option Generator Research)

By picking the worst returns, you'll end up losing about 20% of your initial capital. Selecting the median returns a typical person would achieve (in reality, most retail investors and even professionals are ranked far below the mean) would take you to a gain of 131%!

(Source: Option Generator Research)

(Source: Option Generator Research)

Conclusion: Passive ETF Investing Doesn't Lead To Consistency

A lot of articles have been written about the subject called passive investing with ETFs. Many continue to bank on the 7% returns from the past, stating ETFs create easy income. There are a couple of reasons why buy-and-hold investing in a broad ETF won't work in periods like these:

• Achieving inconsistent returns as shown in the article

• The sizable portion of luck (do we see another serious drawdown over the next decade and how will my nest egg be impacted?)

• Most stocks that an ETF is made up of are positively correlated with each other, especially during corrections. ETFs are thus less diversified than you would think.

• 1-on-1 directional exposure leading to perfectly positive long-term correlation with the stock market

• No ways to reduce your cost-basis; in periods of increasing volatility spreading the risk through monthly investments won't lead to better results (dollar-cost averaging also loses its meaningful impact over time)

• Elevated volatility makes it difficult for most people to stay in the game

• Passive investing relies upon a decent portion of luck/randomness

• The longer it takes for the market to go up, the worse the impact on the compound story will be. Investors don't fully acknowledge the effects of a rangebound market environment, i.e., the Japanese stock market despite massive monetary stimulus. The difference between achieving an annualized 5% and 8% return becomes exponential over time.

Solutions to at least partially solve these problems will be discussed in an upcoming article.