Less pain, more gain: Use ulcer index

Ulcer index is a technical indicator that measures the downside risk in terms of depth as well as the duration of price declines. The value of the ulcer index rises when price moves farther from a recent high and falls when the price rises to new highs. It is believed that the greater the value of ulcer index, the longer it takes to reach up to its former high. Simply put, it is an indicator of volatility on the downside.

Peter Marin and Byron McCann are the people behind the emergence of ulcer index. They developed this index in 1987 for analyzing mutual funds. This was first published in the book ‘The Investor's Guide to Fidelity Funds’. Unlike standard deviation that looks at the overall volatility, The ulcer index only looks at the downside volatility only. The downside is something that causes stress. Various studies have found that more the fall, the more the time it takes to recover your losses. It is always better to be safe than sorry. So, it is important to contain losses, even if it means losing on some of the gains.

To understand it better, we carried out a study, wherein, we calculated the ulcer index and took its median of the last three months. The positive and negative crossovers were taken as an indication to invest in equity or debt. This means that, on instances where the value of the ulcer index was more than its median, the funds were moved to debt and vice versa. For the study, we considered equity as returns on the Sensex and post-tax returns on bank FDs for the debt. Currently, the interest rates on bank FDs are near 6.25 per cent, which post-tax (assuming 30 per cent tax bracket) comes to around 5 per cent. We have assumed that the interest rates on bank FDs remain constant for the entire period of study. Further, for a clearer picture, we are assuming an investment of Rs 1 lakh each is made in both Sensex as well as ulcer investment strategy. The following chart shows how the ulcer investment strategy performed against Sensex over 20 years.

 

In the above chart, the figures plotted on the left axis denote investments made in the Sensex and the ones on the right axis denote investments made using ulcer investment strategy. The above chart clearly shows that the ulcer investment strategy has performed a lot better than the traditional buy and hold strategy. The investment of Rs 1 lakh in the Sensex in April 2000 has grown to Rs 8.10 lakhs. Whereas, the same investment done in April 2000, using ulcer investment strategy, would have grown to whooping Rs 5.61 crore. Although, here, we are ignoring the costs involved in buying and selling of index.

It is said that, rolling returns tells whether the investment is generating consistent enough returns or not. So, to understand this, we calculated the average 1-year, 3-year, and 5-year rolling returns over the period of 20 years. Even here, the investment using ulcer investment strategy proved to be a clear winner. Not just that, but even the difference in the returns generated by the Sensex and the ulcer investment strategy was phenomenal.

Further, let us look at some of the risk return ratios to understand how it has done in relative terms.

As we can see from the above table that, even in terms of risk and return ratios, the ulcer investment strategy is way ahead of the Sensex. Further, on the volatility front, the ulcer investment strategy not only goes ahead in terms of the overall volatility of the investment but also in terms of downside volatility.

So, should you go ahead with this strategy? The answer to this depends on a few things, such as investment tenure and the ability to actively managing the portfolio. If the investment horizon is short-term then it is advisable to avoid using this strategy, as this strategy requires active management ane you need to constantly monitor and take timely actions. On the other hand, if you are looking for creating wealth over a longer period, say by 10 to 15 years and can actively manage it, then this strategy will help you in the same.