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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.

Pain Index - Better Measure of Risk | Swan Global Investments
Source: Zephyr StyleAD­VI­SOR


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, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsMarc 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 020-SGI-052815


By |2017-11-15T13:11:40+00:00May 29th, 2015|Blog|Comments Off on The Pain Index as a Better Measure of Risk