Understanding and monitoring the impact of portfolio drawdowns is crucial for effective portfolio management and making informed investment decisions. By applying appropriate metrics such as a pain index, which measures the intensity and duration of a drawdown, advisers can better manage the risk of their clients’ portfolios and understand the magnitude and duration of drawdowns.

“Drawdowns can have a significant impact on investor psychology. Yet by incorporating drawdown analysis into the portfolio management process, advisers and investors can strive for a better balance between maximising returns and minimising the impact of adverse market conditions,” said Benjamin Walsh, head of research at Padua Solutions.

“Importantly, investors can gain valuable insights and be better prepared for the intensity and duration of drawdowns, well before they happen.

“A pain index, for example, can be a simple but effective measure to evaluate the psychological impact of drawdowns on investors. Padua’s Pain Index is a metric that measures the intensity and duration of drawdowns, with deeper and longer drawdowns being weighted more heavily. A higher Pain Index indicates a greater level of pain experienced by investors during drawdowns,” he said. The figure below illustrates this.

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.”

Stress testing portfolios is another important way for advisers to examine specific drawdown events and how portfolios would cope in simulated scenarios of adverse market conditions.

“The purpose of stress testing is to evaluate the potential vulnerabilities of a portfolio during a market fall, or other potential risks to assess its resilience and performance under those unexpected conditions.  Stress testing involves using historical data or hypothetical scenarios to estimate the impact of adverse conditions on the portfolio's value, returns, risk measures, and other relevant metrics, which better equip investors with knowledge about how market events can affect the value of their investments,” said Mr Walsh.

Another useful tool is The Recovery Time Indicator (RTI), which is a financial risk measurement employed to gauge the duration it requires for an investment to bounce back from a decline. Determining the number of months necessary for an investment to regain its previous peak value after experiencing a drawdown computes it.  

“The RTI serves as a valuable tool for investors as it enables them to evaluate the risk associated with an investment and estimate the potential duration it may take to recover from a loss,” Mr Walsh said.

“Ultimately, a comprehensive approach to tracking drawdowns and measuring their potential impact in different ways, including the above measures, improves the overall risk management framework and contributes to the long-term success of investment portfolios. Such analysis adds to an investor’s understanding of their investments, which will allow them to sleep better at night, particularly during volatile market conditions,” Mr Walsh said.

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