Use the pain index to help pick suitable investment for clientsArticle added by Roccy DeFrancesco on September 9, 2013
Ranked: #4 (11,698 pts)
I really like the pain index. It’s not widely known or used (meaning if you use it, you know it will likely be new to your potential client) and it’s a logical index that is very powerful.
Simply put, the pain index is a risk metric. The pain index deals specifically with the risk of losses or the capital preservation of a manager or benchmark index. The pain index quantifies three measures simultaneously: 1) the depth, 2) the duration and 3) the frequency of losses.
As a metric of capital preservation, the pain index differs from other metrics of downside risk, which focus on volatility or losses versus a benchmark.
Pain index charts
The top of the following chart should look fairly familiar. It’s the S&P 500 returns going back to 1978 (courtesy of Zephyr Associate, Inc.). Over 30+ years, you can clearly see an upward trend. However, there were periods when investors lost significant money in the market (2000-2002 and 2007-2009).
The bottom of the above chart shows the depth of the losses (drawdowns) over the given time frame.
When an investor looks at the top part of this chart, he/she sees two huge market corrections and is incorrectly led to believe that the rest of the time, the market had a pretty smooth and steady increase (at least from 1978 to 1999). In other words, the top part of the chart gives an investor the idea that the S&P 500 wasn’t overly volatile for the major part of this 30-year window.
However, a close look at the bottom part of the chart shows specifically when and what the drawdowns were (negative returns). Shortly after the chart starts, you have a -5 percent, -10 percent, and -18 percent drawdown. Then you’ll notice a -30 percent drawdown before 1989. After 1989, there are several drawdowns prior to the big two market crashes starting in 2000 and again in 2007.
Calculating the pain index
The depth, duration and frequency of loss periods are represented by the blue-hatched area. Ideally, investors want losses to be shallow and short, not steep and wide (long); and, of course, investors want losses to occur as infrequently as possible. That area, divided by the length of time of the analysis, is the pain index.
In terms of values, the smaller the number, the better, as it would equate to a smaller area in the drawdown graph.
Historical pain index numbers
Let’s look at some of the historical pain index numbers by decade.
|Large Cap Stocks (US)||4.67%||1.80%||19.07%||9.78%|
|Small Cap Stocks (US)||7.83%||5.05%||13.58%||10.10%|
|Invst Grade Bonds (US)||1.57%||0.84%||0.48%||7.34%|
|High Yield Bonds (US)||N/A||1.47%||3.48%||8.78%|
The pain index numbers in the 1980s and 1990s don’t have a wide variance. This makes sense, considering the steady gains made through both decades. However, in the 2000s, there were wild swings down and up in the market; and you’ll notice that the pain index jumped accordingly.
The pain index is not the be-all, end-all statistic one would use when analyzing a manager. Instead, it’s just a tool to be used in conjunction with other ways of looking at risk and return, such as RUDR, the Sharpe ratio, downside deviation, etc.
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