Downside Risk: Definition, Example, and How To Calculate

When it comes to investing, understanding and managing risk is crucial. One key type of risk to consider is downside risk, which refers to the potential for an investment to experience a loss. In this article, we will define downside risk, provide an example, and explain how to calculate it.

What is Downside Risk?

Downside risk refers to the potential loss that an investment may experience. It is the opposite of upside potential, which refers to the potential gain an investment may achieve. Downside risk is a critical consideration for investors as it can impact investment returns and the achievement of investment goals.

Downside risk can be impacted by various factors, including economic downturns, company-specific events, and market volatility. It is important to note that not all investments have the same level of downside risk. For example, bonds typically have less downside risk than stocks due to their fixed income nature.

Example of Downside Risk

To better understand downside risk, let’s consider an example. Suppose you invest $10,000 in a stock. The stock has a 50% chance of increasing in value by 20% and a 50% chance of decreasing in value by 10%. The expected return of the stock is calculated as follows:

Expected Return = (50% x 20%) + (50% x -10%) = 5%

The downside risk of the investment is calculated by taking the difference between the expected return and the minimum return:

Downside Risk = Expected Return – Minimum Return

Minimum Return = -10%

Downside Risk = 5% – (-10%) = 15%

In this example, the downside risk of the investment is 15%. This means that there is a 15% chance that the investment will experience a loss of at least 10%.

How to Calculate Downside Risk

There are different methods for calculating downside risk, but one common approach is to use the downside deviation or semideviation. The downside deviation measures the volatility of negative returns and is calculated as follows:

1. Calculate the average return (AR) of the investment over a specific time period.
2. Calculate the negative return deviations (NRD) by subtracting the average return from each negative return.
3. Square each negative return deviation.
4. Calculate the average of the squared negative return deviations (ANRD).
5. Take the square root of the ANRD to calculate the downside deviation.

Downside Deviation = Square root of ANRD

Another method for calculating downside risk is to use Value at Risk (VaR). VaR measures the maximum loss that an investment may experience with a certain level of confidence over a specific time period. To calculate VaR, follow these steps:

1. Choose a confidence level (CL), which is typically 95% or 99%.
2. Calculate the average return (AR) of the investment over a specific time period.
3. Calculate the standard deviation (SD) of the investment’s returns.
4. Calculate the z-score for the chosen confidence level.
5. Multiply the z-score by the standard deviation.
6. Subtract the result from the average return to calculate the VaR.

VaR = Average Return – (z-score x Standard Deviation)

Managing Downside Risk

Managing downside risk is critical for achieving investment goals and protecting portfolios. Here are some strategies that investors can use to manage downside risk:

1. Diversification: Diversification is a strategy that involves investing across different asset classes and securities to reduce the impact of a single event on the portfolio.
2. Stop Loss Orders: Stop loss orders are instructions to sell an investment if it reaches a specific price, limiting the potential loss.

3. Hedging: Hedging involves taking an opposite position in the market to reduce the impact of adverse price movements. For example, buying put options on an investment can limit the potential loss.
4. Risk Management: Risk management involves actively monitoring and adjusting a portfolio to reduce downside risk. This may include selling investments that are underperforming or overvalued.
5. Asset Allocation: Asset allocation is the process of dividing a portfolio among different asset classes to achieve a specific risk and return profile. A well-diversified portfolio that includes a mix of low-risk and high-risk assets can help manage downside risk.

In summary, downside risk is an important consideration for investors as it can impact investment returns and the achievement of investment goals. By understanding and managing downside risk using strategies such as diversification, stop loss orders, hedging, risk management, and asset allocation, investors can better protect their portfolios and potentially achieve their investment objectives.