Pain Index

Pain index refers to a metric of capital preservation developed by Zephyr Associates. It measures risk within losses considering its frequency, duration, and depth, rather than volatility. It serves to assess investments by asset managers, investors, and advisors for its risk related to side-to-side, down, and up.

It helps investors in capital preservation by gaining a highly intuitive comprehension of potential monetary losses. Furthermore, it helps in making informed policy decisions and facilitates economic trend forecasting. In addition, it offers perspective on understanding customer behavior and sentiments. The economic suffrage of a household and an individual can be quantified using it as an economic indicator.

The pain index was developed as a risk measurement index to quantify investment risk. It considers the duration, frequency, and depth of losses. It offers a detailed representation of the downside risk. Unlike standard deviation, which considers both positive and negative returns, this metric focuses solely on negative returns. It attempts to measure the risk through the calculation of the volume between the break-even line and peak-to-trough losses of an investment.

Hence, the index of pain may be taken as the amount of liquid required to fill the space of drawdown. It also means investors would experience a greater volume of pain with increasing depth of losses, increased duration of losses, and a higher frequency of losses.

Furthermore, the volume captures the length and extremity of losses, showing the amount of pain that an investor can endure. Its usage provides a much more vivid picture of possible losses. This aligns more closely with investor considerations regarding the preservation of their capital. Moreover, the standard deviation cannot differentiate between downside and upside volatility and treats all returns as independent events.

In a way, the said index simply measures risk in terms of how much liquidity they may lose, just like the investors themselves think losses to be. As a result, putting the risk measure aligned with investors' common understanding helps them choose managers and funds that suit their needs and objectives. Such an approach helps gain the trust of clients and strengthen client relationships. For investors focused only on capital preservation, it acts as the best means to do so.

This metric can be used in various ways, as follows:

• It helps calculate the index of pain by measuring the frequency, depth, and duration of losses in an investment.
• In combination with return metrics like the pain ratio, it gives a detailed representation of investment efficiency concerning return and risk.
• It helps in comparing the pain ratio and index of pain with that of peer investors or asset class indices to ascertain healthy numbers. This assessment aids in evaluating the performance of the strategy effectively.
• Facilitates getting a highly personalized evaluation of the return and risk of an asset by incorporating risk tolerance and holding period into the index of pain.
• Investors apply this metric in asset allocation decisions to ascertain maximum allocation concerning levels of risk aversion and various holding periods.

Let us use a few examples to understand the topic.

Example #1 

Let us assume that in the town of Old York, there is a large investment firm called Phoenix Fincare. The investment firm is responsible for handling the portfolio of famous and wealthy doctor Rose Stone. Moreover, during the last year, the doctor's investment witnessed ten declines in its value. Hence, Phoenix Fincare was asked to calculate the pain index suffered by the doctor. There had been an average decline in value of 3%, lasting for 30 days duration every time.

Hence, the total score of the pain index was 2.5. The score focused on depth, frequency, and duration of losses instead of volatility, underscoring the requirement for a strategic shift in the investment portfolio. Phoenix Fincare decided to reallocate Rose Stone’s assets to a more stable and robust fund, the Atlas Fund, significantly reducing the portfolio's pain index to a manageable 1.2. As a result, Rose Stone's capital was preserved effectively.

Example #2

An online article published on 1 May 2024 discusses the significance of advisers getting their clients mentally prepared for investing using the pain index. The article emphasizes that tools such as the pain index, drawdown analysis, and maximum drawdown provide valuable insights into the intensity and duration of investment drawdowns. These tools collectively help clients better understand and manage potential risks in their investments.

Further, the article also suggests using the recovery time indicator (RTI) and Stress testing to forecast the recovery times of the portfolio. Additionally, these tools help balance risks and returns. This helps increase clients' knowledge and psychological strength during any market upheaval.

It has become an important metric for measuring risk in markets because:

• It quantifies investors' emotional tension during negative market trends.
• It helps create a risk tolerance level, as a higher index of pain means a volatile portfolio.
• Investors tend to adjust asset allocation as per the pain index, lowering their pain with lower risks.
• It prevents panic selling among investors during downward trends, offering valuable insights.
• It is equitable to the thought process of investors who only think about the total money they might lose.
• Investors seeking capital preservation find it as a better risk metric than standard deviation.