Send a Message

[contact-form-7 id="2362" title="Send a Message"]
twittergoogle_pluslinkedinmailtwittergoogle_pluslinkedinmail

Pain Index: A Better Measure of Risk

Down­load PDF

 

Redefining the Conversation About Risk

His­tor­i­cal­ly, investors quan­ti­fied risk in terms of stan­dard devi­a­tion, more com­mon­ly referred to as volatil­i­ty. Stan­dard devi­a­tion is the most wide­ly used mea­sure of risk in the invest­ing world. The omnipresent Sharpe ratio, which quan­ti­fies the risk-vs.-return trade-off, uses stan­dard devi­a­tion as its mea­sure of risk.

Using volatil­i­ty as the sole def­i­n­i­tion of risk, how­ev­er, holds a num­ber of flaws and can often be mis­lead­ing and at odds with investors’ under­stand­ing of risk. If cap­i­tal preser­va­tion is the pri­ma­ry con­cern of an investor, oth­er met­rics, like the pain index, pro­vide a bet­ter mea­sure of risk than stan­dard devi­a­tion.

 

Standard Deviation has Three Main Flaws:

It fails to distinguish between upside and downside risk.

By def­i­n­i­tion, stan­dard devi­a­tion mea­sures the volatil­i­ty of indi­vid­ual returns around a mean return. Unfor­tu­nate­ly, stan­dard devi­a­tion makes no dis­tinc­tion between the “good” obser­va­tions that fall above the mean and the “bad” returns that fall below the mean. Most investors would not pun­ish a man­ag­er with a high stan­dard devi­a­tion if a good por­tion of the volatil­i­ty was upside volatil­i­ty.

The observations are viewed as independent when they clearly are not.

The more sig­nif­i­cant fail­ing of stan­dard devi­a­tion is that it does not account for the tim­ing of the neg­a­tive returns. If, for exam­ple, a decade has half a dozen excep­tion­al­ly bad months, stan­dard devi­a­tion can­not dif­fer­en­ti­ate whether or not these bad obser­va­tions were ran­dom­ly scat­tered through­out the decade or if they were all con­cen­trat­ed with­in a nar­row time frame. Should the investor care about this flaw in stan­dard devi­a­tion? Yes.

Between 1989 and 2013, sev­en of the worst months in the entire 25 year range of the S&P 500 hap­pened with­in July 2007 and Feb­ru­ary 2009—less than two year time­frame. A fur­ther twelve of the worst months of the last 25 years occurred dur­ing the dot-com bub­ble and the sub­se­quent bear mar­ket at the start of the new mil­len­ni­um.

Log­i­cal­ly, this makes sense. In the midst of a cri­sis, the mar­kets don’t hit a “reset but­ton” and start afresh just because every­one flips the cal­en­dar ahead to a new month. A cri­sis will play out inde­pen­dent of a cal­en­dar, tak­ing how­ev­er long it will take. In the case of the S&P 500, com­pound­ing month after month of epic loss­es result­ed in a max­i­mum draw­down of over 50% between August 2007 and Feb­ru­ary 2009. And yet stan­dard devi­a­tion treats those months as inde­pen­dent obser­va­tions, each one dis­tinct from the next.

Investors don’t think of risk in terms of standard deviation.

Most investors think of risk in terms of cap­i­tal preservation—how much mon­ey they could poten­tial­ly lose.

It’s unlike­ly that many finan­cial advi­sors field calls from angry clients ask­ing, “What was my volatil­i­ty last month?” It’s more like­ly most angry calls are phrased, “How much mon­ey did I lose?”

Stan­dard devi­a­tion is a class­room con­cept; cap­i­tal preser­va­tion is a real-world issue.

This is where the pain index comes in.

 

Pain Index as a Better Measure of Risk

Devel­oped by Dr. Thomas Beck­er and Aaron Moore of Zephyr Asso­ciates, the Pain Index is sim­i­lar to oth­er mea­sures of risk like stan­dard devi­a­tionbeta, track­ing error, etc. Where it dif­fers, how­ev­er, is in its def­i­n­i­tion of risk.

As a cap­i­tal preser­va­tion met­ric, the pain index mea­sures risk in loss­es. Specif­i­cal­ly, it mea­sures the depth, dura­tion, and fre­quen­cy of loss­es.

Measuring Risk in Dollars

In the below graph, the red line rep­re­sents the peak-to-trough loss­es asso­ci­at­ed with the S&P 500 from July 1997 to July 2018. If one were to fill in the entire area between the draw­down line and the break-even line, it would encap­su­late three things: the depth of loss­es, the dura­tion of loss­es, and the fre­quen­cy of loss­es. These three results are exact­ly what the pain index mea­sures.

Pain Index Drawdown - Pain Index - Swan Insights

Source: Zephyr StyleAD­VI­SOR

 

The pain index essen­tial­ly mea­sures the “vol­ume” between the break-even line and the draw­down line.  If the above lines are thought of as mea­sur­ing cups, the pain index is the vol­ume of liq­uid required to fill the draw­down space. The deep­er the loss­es, the longer the loss­es and the more fre­quent the loss­es, the larg­er the vol­ume of “pain.”

The steep­est draw­down was the cred­it cri­sis of 2007-08 when the S&P 500 lost over 50%. How­ev­er, the longest draw­down was the dot-com bust of 2000–2002. Dur­ing that stretch, the mar­ket was down “only” 45% but took longer to recov­er its loss­es- 49 months for the dot-com bust, 37 months for the cred­it cri­sis, as we can see in the chart above.

Using the Pain Index Metric

When look­ing at the pain index mea­sure­ment, the investor would pre­fer that vol­ume to be as small as pos­si­ble. The small­er the pain index, the bet­ter. A zero would be the best, indi­cat­ing the man­ag­er nev­er lost mon­ey.

The safest invest­ments with the low­est pain index­es are like­ly to be those invest­ments with scarce­ly any upside, like sav­ings accounts, cer­tifi­cates of deposit, or mon­ey mar­kets.

 

Measuring Risk how Most Investors Think about Risk

The pain index mea­sures risk in terms most investors think about risk: how much mon­ey they might lose.

Putting risk in terms investors under­stand is impor­tant for help­ing them decide on funds and man­agers that suit their objec­tives and needs. Empathiz­ing with their con­cerns and doing so with prop­er mea­sure­ments can help you gain your clients’ trust and bol­ster your client rela­tion­ship.

The pain index is great for investors who are more con­cerned with cap­i­tal preser­va­tion above all else. But since invest­ing is all about opti­miz­ing returns against risks, we ide­al­ly want a met­ric that mea­sures the bal­ance of the pain index against a mea­sure of return. This is the pur­pose of the pain ratio, which I’ve dis­cussed in a dif­fer­ent post.

 

About the Author:

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsMarc Odo, CFA®, CAIA®, CIPM®, CFP®, Client Port­fo­lio Man­ag­er, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly, Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.

 

 

 

 

Important Disclosures

*Orig­i­nal­ly pub­lished May 2015

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non-qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®).

All Swan prod­ucts uti­lize the Defined Risk Strat­e­gy (“DRS”), but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS prod­uct offer­ings will have dif­fer­ent per­for­mance results due to offer­ing dif­fer­ences and com­par­ing results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or www.swanglobalinvestments.com372-SGI-092118

By |2018-10-22T17:13:06+00:00October 18th, 2018|Blog|Comments Off on Pain Index — Better Measure of Risk