The 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 deviation, beta, tracking error, etc. Where it differs, however, is in its definition of risk. As a capital preservation metric, the pain index measures losses. Specifically, the pain index is the depth, duration, and frequency of losses.
Pain Index vs. Standard Deviation
At Swan Global Investments, we are big proponents of a risk metric known as the “pain index.” Of the dozens of performance-based metrics available, we believe the pain index is a more appropriate way of quantifying the risk that most investors care about. In other words, the pain index is all about measuring capital preservation.
The more common measurement of risk is standard deviation, but it has many shortcomings:
1) It fails to distinguish between upside and downside risk.
2) The observations are viewed as independent when they clearly are not.
Other benchmark-relative measures like alpha and information ratio may be positive even if the investment itself lost half of its value while maximum drawdown fails to account for the time to recovery or any of the secondary losses.
Drawdown and Recovery
In the below graph the brown line represents the peak-to-trough losses associated with the S&P 500 from July 1997 to December 2014. 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.
Advantages of the Pain Index
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.” Obviously, 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.
Capital preservation and minimizing losses has always been the core mission of Swan Global Investments, as seen in the graph above, the blue area is the “pain” experienced by Swan’s Defined Risk Strategy. Compare that area to the area created by the more severe moves of the red line, indicating the S&P 500 index. By hedging the market risk at all times, during the two big bear markets since 1997, Swan’s pain index was a fraction of that of the S&P 500 index.
The “pain index” does a great job summarizing what Swan is all about.
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About the Author:
Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions, 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: Swan offers and manages the proprietary Defined Risk Strategy (“DRS”) for its clients including individuals, institutions and other investment advisor firms. Swan’s DRS performance results herein are of the DRS Select Composite which includes all non-qualified accounts. Additional information regarding Swan’s composite policies and procedures for calculating and reporting performance returns is available upon request. All Swan performance results have been compiled solely by Swan Global Investments and are unaudited. Other performance return figures indicated in this material are derived from what Swan believes to be reliable sources (i.e., S&P 500 index, other indexes and benchmarks), but Swan does not guarantee its reliability. This analysis is not a guarantee or indication of future performance. Investments in foreign securities involve additional risks including currency risk. References to the S&P 500 and other indices and benchmarks are for informational and general comparative purposes only. Indexes are unmanaged and have no fees or expenses. An investment cannot be made directly in an index. The adviser’s dependence on its DRS process and judgments about the attractiveness, value and potential appreciation of particular investments, ETFs and options in which Swan invests or writes may prove to be incorrect and may not produce the desired results. Swan Global Investments, LLC, Swan Capital Management, LLC, Swan Global Management, LLC and Swan Wealth Management, LLC are affiliated entities. Further information is available upon request by contacting the company directly at 970–382-8901 or www.swanglobalinvestments.com. 020-SGI-052815