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 risk in losses. Specifically, it measures the depth, duration, and frequency of losses.
Measuring Risk in Dollars
In the graph below, we look at a 20-year period with two full-market cycles (both a bull and bear market), from July 1997 to July 2018. The red line represents the peak-to-trough losses associated with the S&P 500. If one were to fill in the entire area between the drawdown line and the break-even line, it would encapsulate three things: the depth of losses, the duration of losses, and the frequency of losses. These three results are exactly what the pain index measures.
Source: Zephyr StyleADVISOR
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.”
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, as we can see in the chart above.
Using the Pain Index Metric
When looking at the pain index measurement, 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.
The safest investments with the lowest pain indexes are likely to be those investments with scarcely any upside, like savings accounts, certificates of deposit, or money markets.