Loading the player...

What is 'Downside Risk'

Downside risk is an estimation of a security's potential to suffer a decline in value if the market conditions change, or the amount of loss that could be sustained as a result of the decline. Depending on the measure used, downside risk explains a worst case scenario for an investment or indicates how much the investor stands to lose.

BREAKING DOWN 'Downside Risk'

Some investments have a finite amount of downside risk, while others have infinite risk. The purchase of a stock, for example, has a finite amount of downside risk; the investor can lose his entire investment. A short position of a stock, however, as accomplished through a short sale entails unlimited downside risk, since the price of the security could continue rising indefinitely.

Investors, traders and analysts use a variety of technical and fundamental metrics to estimate the likelihood that an investment's value will decline, including historical performance and standard deviation calculations. In general, many investments that have a greater potential for downside risk also have an increased potential for positive rewards. Investors often compare the potential risks associated with a particular investment to its possible rewards. Downside risk is in contrast to upside potential, which is the likelihood that a security's value will increase.

A Common Downside Risk Measure and Example

With investments and portfolios, a very common downside risk measure is downside deviation, which is also known as semi-deviation. This measure is a variation of standard deviation in that it measures the deviation of only bad volatility. It measures how large the deviation in losses is. Since upside deviation is also used in the calculation of standard deviation, investment managers may be penalized for having large swings in profits. Downside deviation addresses this problem by only focusing on negative returns.

For example, assume the following 10 annual returns for an investment: 10%, 6%, -12%, 1%, -8%, -3%, 8%, 7%, -9%, -7%.

Standard deviation, which measures the dispersion of data from its average, is calculated as:

Standard deviation = Square root of ((x - u)2 / n)

Where:

x = data point

u = dataset average

n = number of data points

The formula for downside deviation uses this same formula, but instead of using the average, it uses some return threshold. Often the risk-free rate is used or a hard target return. In the above example, 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%. Breaking out the bad volatility from the good volatility shows investors a better picture. This shows that about 40% of the total volatility is coming from negative returns. This implies that 60% of the volatility is coming from positive returns. Broken out this way, it is clear that most of the volatility of this investment is "good" volatility.

RELATED TERMS
  1. Downside

    The negative movement in the price of a security, sector or market. ...
  2. Empirical Rule

    A statistical rule stating that for a normal distribution, almost ...
  3. Residual Standard Deviation

    The residual standard deviation is a statistical term used to ...
  4. Bell Curve

    A bell curve is the most common type of distribution for a variable.
  5. Post-Modern Portfolio Theory - ...

    A portfolio optimization methodology that uses the downside risk ...
  6. Risk Assessment

    The process of determining the likelihood that a specified negative ...
Related Articles
  1. Investing

    The Uses And Limits Of Volatility

    Check out how the assumptions of theoretical risk models compare to actual market performance.
  2. Trading

    Improve Your Investing With Excel

    Excel is a useful tool to assist with investment organization and evaluation. Find out how to use it.
  3. Investing

    PRHSX: Risk Statistics of Health Sciences Mutual Fund

    Examine the risk metric of the T. Rowe Price Health Sciences Fund. Analyze beta, capture ratios and standard deviation to assess volatility and systematic risk.
  4. Investing

    Understanding Volatility Measurements

    How do you choose a fund with an optimal risk-reward combination? Here we teach you about standard deviation, beta and more.
  5. Investing

    6 Risks Threatening Your Portfolio Today

    Factoring in these risks is crucial when building a portfolio.
  6. Trading

    Trading With Gaussian Models Of Statistics

    The study of statistics originated from Carl Friedrich Gauss and helps us understand markets, prices and probabilities, among other applications.
  7. Investing

    Using Normal Distribution Formula To Optimize Your Portfolio

    Normal or bell curve distribution can be used in portfolio theory to help portfolio managers maximize return and minimize risk.
  8. Investing

    Tips For Investors In Volatile Markets

    Find out what to look out for when trading during market instability and how to adjust your investment strategies to best handle the volatility.
  9. Investing

    Managing for Downside Risk

    Active managers may never beat indexes, but they reduce downside risk, which is a long-term benefit.
RELATED FAQS
  1. How is standard deviation used to determine risk?

    Understand the basics of calculation and interpretation of standard deviation, and how it is used to measure and determine ... Read Answer >>
  2. What does standard deviation measure in a portfolio?

    Dig deeper into the investment uses of and mathematical principles behind standard deviation as a measurement of portfolio ... Read Answer >>
  3. What is the difference between standard deviation and average deviation?

    Understand the basics of standard deviation and average deviation, including how each is calculated and why standard deviation ... Read Answer >>
  4. How is risk aversion measured in Modern Portfolio Theory (MPT)?

    Find out how risk aversion is measured in modern portfolio theory (MPT), how it is reflected in the market and how MPT treats ... Read Answer >>
  5. What is the difference between standard deviation and z score?

    Understand the basics of standard deviation and Z-score; learn how each is calculated and used in the assessment of market ... Read Answer >>
  6. How can you calculate volatility in Excel?

    Historical volatility is a long-term assessment of risk. Here's how to calculate it in Excel. Read Answer >>
Hot Definitions
  1. Treasury Yield

    Treasury yield is the return on investment, expressed as a percentage, on the U.S. government's debt obligations.
  2. Return on Assets - ROA

    Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets.
  3. Fibonacci Retracement

    A term used in technical analysis that refers to areas of support (price stops going lower) or resistance (price stops going ...
  4. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  5. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  6. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
Trading Center