Gain-to-pain ratio helps set your risk level
Ratio can also be used to compare money managers
If “no pain, no gain” is more than just a cliché, how much pain are investors willing to endure in order to gain a better return is an important question.
Finding an answer isn’t easy at the best of times, but the gain-to-pain ratio used by a growing number of professional money managers is one way to figure it out.
“We need to evaluate our very justified fears of investing from a different perspective,” said Stuart Campbell, a lead portfolio manager at Toronto-based One Financial Corp., in a recent note to clients. “We need to be able to make risk-adjusted decisions. In this way we can better decide how to invest our money, and how much of it we can park.”
Mr. Campbell said the gain-to-pain ratio is one of the best tools for assessing an investor’s risk/return balance. The ratio, as he explains it, is calculated by measuring the expected gain or return of an investment and dividing it by the potential pain or drawdown, which is the worst peak-to-trough drop in value over time.
For example, take a stock that rises to $10, falls to $5, before rebounding to $15. The worst drawdown is the drop from $10 to $5, or 50%.
“Worst drawdown is a simple and effective way to define pain, or risk,” he said. “To determine our own pain threshold, we have to ask ourselves, ‘What is the maximum percentage loss I am willing to tolerate to accomplish potential gains?’ Is it 10%, 30%, 100%, or somewhere in between?”
The gain-to-pain ratio for an investor who wants an annual return of 10% and is willing to tolerate a maximum drawdown of 20% is 0.5. An investor expecting an annual return of 15% with a drawdown of 50% has a gain-to-pain ratio of 0.3.
Mr. Campbell said investors with lower ratios are willing to accept less gain per unit of risk even though they may have a higher absolute return target.
Furthermore, an investment that has a gain-to-pain ratio lower than desired would not provide enough return per unit of risk.
Jack Schwager, the U. S. investment manager best known for writing the Market Wizards book series, said the gain-to-pain ratio is also an excellent metric for comparing professional money managers, but it isn’t foolproof.
We need to be able to make risk-adjusted decisions
He said the inherent risks of many hedge-fund strategies, for instance, may occur only sporadically and may not be evident in the track record of the manager’s portfolio.
For example, he told Abnormal Returns, a U.S. investment blog in June, “that a manager who sells out-of-the-money options could have an extremely smooth equity stream and look like he has very low risk, as long as there hasn’ t been any abrupt, large price move during the lifespan of the track record.
He added that such a manager could also have an excellent gain-to-pain ratio.
“However, in this example, the true risks of the strategy are not reflected in the track record,” he said. “So it is very important to make this distinction — that is, whether risks inherent in the strategy are adequately reflected by past returns.”