Downside risk plays an important role in every investor’s life, as it is an estimation of a security’s potential loss in value if the market conditions precipitate in that security’s price. Depending on the measure used, it explains the worst outcome for investment as well as indicates how much the investor stands to lose. Interestingly, downside risk measures are considered one-sided tests since the potential for profit is not considered.
It is desirable to understand the downside risk, as it helps to deal with challenges. Inexperienced investors should keep in mind that some investments have a finite amount of downside risk, while others have infinite risk.
For example, the purchase of a stock has a finite amount of downside risk bounded by zero. Investors can lose their entire investment, but not more. A short position in a stock, nonetheless, as accomplished through a short sale, entails unlimited risk since the price of the security could continue rising indefinitely.
Similarly, being long an option-either a call or a put-has a risk limited to the price of the option’s premium. However, a short call option position has an unlimited potential downside risk. This is due to the fact that there is theoretically no limit to how far a stock can climb. In the case of short puts, the situation is different. They have limited downside risk because the stock or market can’t fall below zero.
Investors and analysts use a variety of technical and fundamental metrics to estimate the likelihood that an investment’s value will decline. This includes historical performance and standard deviation calculations. Importantly, many investments that have a greater potential for downside risk also have an increased potential for positive rewards.
In many cases, investors compare the potential risks associated with a particular investment to possible rewards.
Downside risk vs. upside
The downside risk is the opposite of upside potential, which is the likelihood that a security’s value will increase. Interestingly, it refers to the potential increase in value, measured in monetary or percentage terms, of an investment. Analysts like to use technical analysis or fundamental analysis techniques to predict the future price of an investment. This is particularly true for stock prices. As a reminder, a higher upside means that the stock has more value than it currently reflects in the stock price.
Arguably, the concept of upside is the main driving factor for an individual to invest. The magnitude of upside will rely primarily on the risk associated with that investment. The market axiom of high risk/high reward holds true when it comes to choosing whether to commit to or pass on an investment.
In most scenarios, investors with a high tolerance for risk will increase will choose investments with huge upside. Investors with a lower tolerance for risk will opt for investments that have limited upside but will be more apt to preserve their initial investment value.
Upside and its importance
Upside not only refers to an investment’s potential gains in potential value, but the upside is also a concept used to judge the success of a portfolio manager’s performance when compared to a benchmark. For many mutual funds, the goal of the investment is to outperform a specific benchmark, such as the Standard & Poor’s 500 indexes. The upside capture ratio shows how much upside the mutual fund captures when compared to the benchmark.
The upside is also important when it comes to short selling. Short selling refers to the sale of stock that an investor doesn’t own. In short selling, the seller has to deliver borrowed securities to the buyer by the settlement date. Eventually, the seller must buy shares to cover the short position. His or her goal is to buy back shares at a lower price. Short-sellers are looking for stocks that reached their upside potential, which means the stock’s potential to decline increases.
Downside risk and its examples
Let’s look at examples of downside risk. With investments and portfolios, a widespread downside risk measure is downside deviation, which is also known as semi-deviation. This measurement is a variation of standard deviation in that it gauges the deviation of only bad volatility. Notably, it measures how large the deviation in losses is.
Since upside deviation is also utilized in the calculation of standard deviation, investment managers may be penalized for having large swings in profits. Downside deviation deals with this problem by only focusing on negative returns.
The formula for downside deviation uses the same formula as the standard deviation. However, instead of using the average, it uses some return threshold-the risk-free rate is often used.
Presume the following 10 annual returns for an investment: 10%, 6%, -12%, 1%, -8%, -3%, 8%, 7%, -9%, -7%. In the example mentioned above, any returns that were less than 0% were used in the downside deviation calculation.
The standard deviation for this data set is 7.69%. The downside deviation of this data set is 3.27%. This shows that about 40% of the total volatility derives from negative returns. It also suggests that 60% of the volatility is coming from positive returns. Broken out this way, it is evident that most of the volatility of this investment is “good” volatility.
Investors and analysts sometimes like to use other downside risk measurements, such as Roy’s Safety-First Criterion (SFRatio). Thanks to SFRatio, it is possible to evaluate portfolios based on the probability that their returns will fall below a minimum desired threshold. Here, the optimal portfolio will be the one that minimizes the probability that the portfolio’s return will decline below a threshold level.
At an enterprise level, the most widespread risk measure is probably Value-at-Risk (VaR). It estimates how much a company and its portfolio of investments might lose with a given probability, given typical market conditions, etc.
Regulators, analysts, and firms are regularly using VaR to estimate the total amount of assets needed to cover potential losses predicted at a certain probability.