1) It really boils down to whether you agree with the following statement:
Investors should take the least amount of risk to reach their investment goals
If you do not agree with that statement, then you really have no business reading or caring about what’s in this book.
Page 31 of the book.
2) The Pain Index
The pain index quantifies three measures simultaneously: 1) the depth, 2) the duration, and 3) the frequency of losses. As a metric of capital preservation, the pain index differs
from other metrics of downside risk, which focuses upon volatility or losses vs. a benchmark. Once established, the pain index can be utilized in a return vs. risk trade-off metric.
3) Maximum drawdown is defined as the maximum percentage loss from an investment peak to a negative trough after the peak. The following chart of SPY (SPDR S&P 500 ETF) between 2005 to the end of 2012 shows the maximum drawdown of this period (-55.2%) as well as the secondary large drawdown (-18.6%) in 2011.
In English please…ok, so, from 2005 to 2012, the S&P 500 generated an average rate of return of 4.9%. To generate that ROR, the investor had to risk a 55% loss over that time frame.
If your financial planner said to you that you could achieve an average rate of return of 4.9% and that you “only” had to risk 55% of your money to do so, would you take that investment? NO WAY!
4) I ask you, if you understood the maximum drawdown risk in 2011, would you have risked 18.6% of your money to generate a 2.11% rate of return? NO WAY!
Did you know that 2011 was the most volatile year in decades?
As I just stated, the S&P 500 was up 2.11% for 2011. That doesn’t seem volatile. If an investor only looked at his/her investment statement on January 1, 2011, and then again on January 1, 2012, he/she would see that 2.11% return. As such, the investor might think it could have been a better year but that it was nice to have some amount of positive returns over the year.
But I just asserted that 2011was a hugely volatile year. Let’s look at a chart that will illustrate the volatility.
Overall, the S&P had approximately 13 countertrend moves of approximately 7% or greater. There were six instances where the S&P 500 index had a drawdown of -7% or more during 2011.
If six 7% drops don’t get an investor’s attention, maybe a -18.61% drop will? I think so, and that’s exactly what happened in 2011.