Measure risk in losses, not volatility
It is commonly said, “To make money in the stock market you must take some risk.” Risk is defined as the potential for loss. But if that’s the definition, why aren’t we measuring risk that way?
In the investment industry, risk is often associated with variance or standard deviation—measures of volatility that help approximate risk. They measure investment returns around an expected or average return. The difference from the actual to expected return is counted in standard deviation and the higher the number, the more risk an investment potentially carries.
But let me ask this, “How many times have you heard investors define risk in terms of standard deviation?” I’ll bet it’s not very often. Investors don’t use statistical jargon. Risk to them means running out of money – or not being able to retire in the first place. In addition, what troubles me about this common measure of risk is the calculations work for the positive returns and negative returns alike. I do not mind upside surprises; it is the downside I am concerned about.
So, what’s a better measure of risk?
A better measure of risk is one that measures risk in losses, not volatility. One of the often-missed components of risk is longevity risk. If investment A is down 5% in a week but recovers the next week, how does it differ when investment B is down 5% but does not recover for a month? When evaluating risk, I like to look at both the up and down as well as the side-to-side risk.
That’s why I believe more asset managers, advisors and investors should measure risk with the Pain Index. The Pain Index can help us evaluate investments for the up, down, and side-to-side risk. Developed by Zephyr Associates, the Pain Index adds the side-to-side component of risk by measuring the volume of time an investment is below the zero line (or losses). The greater the drawdown (Depth), the longer period of time before the investment turns positive (Duration), and the number of times an investment goes negative (Frequency) leads to a larger pain index. A Pain Index of zero means the investment never lost value.
Pain Index = Depth + Duration + Frequency. These are the types of things that will cause pain for clients.
How can you use the Pain Index?
The Pain Index can be a tool for advisors to help them define and measure risk in terms investors can feel and relate to—how much money they might lose. Being mindful of loss when helping investors choose investments can lead to a better experience and help keep them on track toward their goals. Losing less to gain more is a philosophy we believe in at Frontier Asset Management. It’s our Downside First Focus process, which sets a downside target for each strategy we manage—essentially seeking to minimize the Pain Index.
I would argue the common phrase should be “To make money in the stock market you need to take the right risk for you and intelligently try to limit your downside.” Let’s make the investment journey to client goals as smooth as possible. And remember, the closer the pain index is to zero, the better.