Advisers should utilise a ‘pain index’ to mentally prepare clients

Speaking on psychological impacts of investing, Benjamin Walsh, Padua Solutions head of research, said there are a number of valuable portfolio assessment and management tools advisers can use to help clients better understand the potential risks associated with their investments and mentally prepare for them.

“Drawdowns can have a significant impact on investor psychology,” Walsh said.

“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.

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

According to Walsh, calculating the maximum drawdown is important as it allows clients to compare investments and mentally prepare themselves in case it does come to pass, hopefully minimising psychological distress.

“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,” he 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.”

Discussing tools available to advisers, Walsh said the pain index can be used to understand the potential psychological impact of market changes on a client.

“A pain index can be a simple but effective measure to evaluate the psychological impact of drawdowns on investors,” he said.

“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 added that stress testing can also be used to prepare investors for varying market conditions and the impact that could have on their portfolio.

“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,” Walsh said.

The recovery time indicator (RTI), he said, allows investors peace of mind armed in the knowledge their portfolio will recover and provides them with a potential time frame for recovery.

“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,” Walsh said.

In providing investors with a variety of tools, he added that clients are able to form a more comprehensive understanding of how their portfolio may react under certain conditions, allowing them to mentally prepare.

“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,” he said.

“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.”