Losing money is a painful experience. The pain index attempts to measure the complete scope of losses. It addresses the shortcoming of only looking at maximum drawdown. It measures risk in terms of absolute returns.
There is no hard-and-fast rule or breakpoint that separates a good pain index from a bad one. One must compare a manager’s pain index against an appropriate benchmark or peergroup in order to gain an understanding of whether a manager’s pain index is good or bad.
It can be said that the lower the number the better. The investor would prefer 1) smaller overall losses, 2) shorter periods of loss, and 3) infrequent losses. All three of these would translate to a smaller pain index. A pain index of zero would represent the best possible outcome, meaning the investment never lost value.
The pain index completely ignores the upside. An investment with a very high pain index signifying a lot of losses might also have a large number of gains too. The gains are not captured by the pain index.
The upper half of the image is simply a cumulative return graph, commonly known as a “Growth of $100” chart. The drawdown graph beneath hones in on the periods of losses. The drawdown graph illustrates what the pain index quantifies. The depth, duration, and frequency of losses are seen on the drawdown graph.
The pain index quantifies the losses illustrated on the drawdown graph. It is the shaded area on the drawdown graph. Obviously the investor hopes this area to be as small as possible.
Unfortunately there isn’t a single value that can be described as “typical” when it comes to understanding the pain index. There are two very important elements one should keep in mind, namely, the asset class under consideration and the time frame. Risky asset classes like emerging market equities have exhibited periods of significant losses. Investment grade bonds, on the other hand, have historically experienced very little “pain” area. The other key contextual element is the time frame. In the 1980s and 1990s, losses were few and far between. In the 2000s, losses were much more common with the Dot-Com Bust and the Credit Crunch.
The pain index is derived by calculating an integral measuring the area between a curve (e.g., the drawdowns) and the zero line separating periods of gains from losses. The integral is then divided by the length of the X-axis, representing the time frame.
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