Financial advisers can better inform their clients and help them cope with volatile times by utilising a “pain index’, according to adviser financial technology firm, Padua.
Padua’s head of research, Benjamin Walsh said applying appropriate metrics such as a pain index measuring the intensity and duration of a drawdown assisted advisers to manage client portfolios and to understand the magnitude and duration of drawdowns.
He says a pain index can be a simple but effective measure to evaluate the psychological impact of drawdowns on investors with the Padua pain index measuring the intensity and duration of drawdowns, with deeper and longer drawdowns weighted more heavily.
“A higher Pain Index indicates a greater level of pain experienced by investors during drawdowns,” Walsh said.
He said investors also need to understand the impact of a maximum drawdown. To calculate the maximum drawdown, the highest peak value of the investment or portfolio is identified, and then the lowest trough value is determined. The percentage difference between the peak and trough is measured, providing the maximum drawdown.
“Maximum drawdown is an important metric in evaluating the risk and potential downside of an investment. It helps investors understand the worst-case scenario regarding losses they may encounter from their investments. A larger maximum drawdown indicates higher losses and higher risk, while a smaller maximum drawdown suggests lower losses and lower risk during the same market conditions,” Mr Walsh said.
“This number is useful in comparing investments. It tells you which investments would have been more likely to sustain more damage during market downturns. The higher this number is, the worse off your investments may have fared during bear markets or recessions,” Walsh said.
