THE INVESTOR PAIN INDEX

The investment industry throws around all sorts of statistics regarding the risk of particular investments.  They even have a measure of investment performance that they call “risk adjusted returns”. 

For every investment, the industry calculates:

• Beta (a measure of volatility)

• The Sharpe Ratio (a way to compare risk adjusted returns)

• Standard Deviation (another measure of volatility)

Do you find these statistics helpful?  How do you feel about a Sharpe Ratio of 1.5 compared to a Sharpe Ratio of 2.7?  They don't help me.

The typical investment advisor also asks clients to fill out a risk profile survey.  The objective is to see how much risk a person is willing to take to achieve higher returns.  But do people really understand what a higher or lower risk profile score means?  Can the advisor somehow magically dial in the perfect investments to match a risk profile score?  The answer to both questions is NO.

The reality is that the industry’s preferred risk measurements don’t tell investors what they want to know.  So, I created my own.

What investors are concerned about is:

1. How much money could I lose?

2. How long will the losses last?

Drawdown

I have always felt that Drawdown is the most important statistic that measures risk for any investment because it measures risk in a way that we all can relate to. 

Drawdown is simply the maximum percentage decrease for an investment in a particular time period.  Drawdown is most typically utilized during bear markets.  It measures the peak to trough decline during a time period.

For example, the Nasdaq Index reached an all-time high of 5,048.62 on 3/10/2000 just before the dot-com crash occurred.  Over the next couple years, it dropped to a low of 1,114.11 on 10/9/2002.  This percentage decline of 77.9% represented a drawdown of 77.9%.

Time to Recover

Losing a lot of money with a high drawdown is painful but losses are even more painful if they last a long time.  If the value of an investment goes down but recovers quickly, we experience less pain.

I measure Time to Recover as the time between the pre-crash peak and the time that an investment gains back all of the losses and returns to the pre-crash peak. I measure time to recovery in years.

In my Nasdaq example from the year 2000 above, the Nasdaq index did not return to the pre-crash peak of 5,048.62 on 3/10/2000 until 07/16/2015.  The time to recover in this case was 15.3 years.  If you had $100,000 invested in the Nasdaq in early 2000, you would have seen your investment drop all the way to about $22,000 and you would not have recovered those losses for 15 years. Now that is painful.

Older investors need to pay close attention to recovery time.

The Investor Pain Index

I calculate the Investor Pain Index as the product (multiplication) of the two important risk statistics – drawdown and time to recovery.

For example, a drawdown of 30% that includes a 3-year time to recovery produces an Investor Pain Index of 90 (3 times 30).

The higher the score, the more pain that is inflicted upon the investor.  So, we are all looking for investments that have high returns and a lower Investor Pain score.

Below is a table comparing the bear market averages for the last 50 years of the S&P 500, the Nasdaq and my Market Signals investment system. 

In a typical bear market in stocks, we can expect the S&P 500 to drop around 39% and the Nasdaq to drop around 45%.  And it takes around 4 years for both indices to rebound from those losses and get back to even.  The investor pain index is 174 for the S&P 500 and 267 for the Nasdaq.  This is why people talk about the Nasdaq being more volatile than the S&P 500.  It typically posts higher returns than the S&P but it tends to lose more money in downturns.

Compare the two major stock indices to our Market Signals system. This one chart shows you exactly why we created Market Signals.  It incurs lower losses in bear markets (14%) and gets back to even much faster (1.6 years).  The Investor Pain Index for Market Signals is only 24 or about 90% less than the major stock market indices. 

Even better, during bull market expansions, Market Signals posts gains that are similar to the S&P 500 and the Nasdaq.  This is how we are able to beat the market.  Losing less in bear markets equals higher overall gains.  It is simple math. 

I encourage you to look at your own investments this way.  Look at how much money your investments lost in previous bear markets and how long they took to recover.  These are the two most important risk statistics in investing. 

Stay Disciplined My Friends,

Phil McAvoy

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Investing in the financial products discussed in the Newsletter involves risk. Trading in such securities can result in immediate and substantial losses of the capital invested. Past performance is not necessarily indicative of future results. Actual results will vary widely given a variety of factors such as experience, skill, risk mitigation practices, and market dynamics.