Downside Volatility vs. Long-term Wealth
pleasure from gains, then a disconnect clearly exists. Some academics and practitioners have tried to resolve the difference by creating of various measures to assess risk.
One of them is the “Pain to Gain” ratio. Recently on the Financial Planning website, Craig Israelsen explained this formula. It divides the standard deviation of return by the actual return. The standard deviation, in this case, is the amount an asset’s return deviates from its typical range of returns. You can calculate it by downloading return data from a website such as Yahoo Finance and using the “STDEV” function in Microsoft Excel. In describing the indicator, Israelsen wrote, “We want to experience less volatility (pain) for a given level of return (gain)—so the lower an investment’s score, the better.” (Israelsen used rolling 10-year period returns in his article, but told me in an email that 36-month periods can also be used. The more common practice for calculating risk measures is to use monthly returns for the past 36 months.)
At AAII, we use a similar but slightly different measure: the risk index. This is the standard deviation of a fund’s or portfolio’s return divided by the standard deviation of return for a benchmark. The benchmark can be a broad market index (e.g., the Dow Jones U.S. index) or a fund’s category average. A score of 1.0 indicates greater risk than the index and values below 1.0 indicate lower risk. This measures tell you whether or not a portfolio (or a fund) has incurred greater price volatility than its benchmark.