Quantifying pain via drawdown size by Richard Harrison
Most investors want the greatest return on their investment as long as their pain threshold is not exceeded along the way. The amount of pain an investor experiences depends not only on the size of drawdowns, but also on how long the drawdowns last.
An investor can quantify both pain components of drawdown on an equity vs. time plot by measuring the area of the drawdown (DA). DA is the sum of the drawdown percentages for each time period for the duration of the drawdown. Summing the individual DAs results in the total drawdown area (TDA), which is an indication of the amount of pain an investor would have experienced over the evaluated time period. An investor's experience of pain depends on how he or she perceives the individual and combined threats of percentage drawdown and its duration. The curves for percentage and duration are not necessarily the same. It is possible for an investor to be nonlinear about percentage drawdown and linear about its duration, or vice versa. Some investors have defined limits on the amount of pain they are willing to experience.
These perceptions of threat, or pain, can be graphed and are sometimes referred to as risk-aversion curves. An investor who is immune to the percentage or duration of a drawdown is represented by curve A in Figure 2. I've found this condition is very rare and short-lived.