The probability that an asset or security will fall in price
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Written byCFI Team
What is Downside Risk?
Downside risk refers to the probability that an asset or security will fall in price. It is the potential loss that can result from a fall in the price of an asset as a result of changing market conditions.
Downside risk can also be described as a statistical measure that aims to calculate and quantify the worst-case loss that can result from uncertainty in the difference between expected return and realized return in cases where market conditions deteriorate.
Investors are worried about risk, which represents security deviation on the upside and downside. However, they are more worried about losing their capital than the level of positive investment return they can attain; hence, downside risk becomes paramount. It helps in calculating risk on returns that fall short of the minimum acceptable return (MAR). Securities with high downside risk should compensate with high expected returns.
How to Calculate Downside Risk
Standard deviation is the most popular measure used to calculate risk, but it measures total risk, which includes both the upside and downside risk. Downside risk focuses only on the downside deviations from the mean. It can also be calculated using a variety of ways; however, we will illustrate the use of semi-variance to measure downside risk, which is a widely accepted method.
We hypothesize a company called City Electric Inc. with past annual returns from 2012 to 2019, as tabulated below. The minimum acceptable return (MAR) that investors require on the stock is 9%.
Using the semi-variance method, we subtract MAR from each year’s actual return. We then select negative returns only, as they represent downside deviations, and we square them and sum the squared deviations. The resultant figure is divided by the number of periods under study, then we find the square root of the answer, which gives us the downside risk.
The higher the figure, the higher the risk; therefore, it is important to compare the downside risk and that of similar comparable companies to ascertain if the downside risk is too high or acceptable.
| City Electric Inc. | |||||
| Year | Annual Stock Returns | MAR | Absolute Deviation | Negative Returns | Squared Values |
| 2012 | 14% | 9% | 5% | ||
| 2013 | 8% | 9% | -1% | -1% | 0.01% |
| 2014 | -4% | 9% | -13% | -13% | 1.69% |
| 2015 | -6% | 9% | -15% | -15% | 2.25% |
| 2016 | 9% | 9% | 0% | ||
| 2017 | 17% | 9% | 8% | ||
| 2018 | 9% | 9% | 0% | ||
| 2019 | -11% | 9% | -20% | -20% | 4.00% |
| Mean Return / Sum of Squared Returns | 4.50% | 7.95% | |||
| Divided by No. of Years | 1.14% | ||||
| Square Root | 10.66% | ||||
| Downside Risk | 10.66% | ||||
| Risk-Free Rate | 3% | ||||
| Sortino Ratio | 14% | ||||
Downside risk is fairly easy to calculate for financial instruments such as equities and fixed income. However, other complex products – such as credit default swaps and options – are fairly complicated to calculate.
Management of Downside Risk
Before considering downside risk management strategies, it is important to examine specific investor qualities, which helps guide investors to the appropriate strategy to employ on an investment or portfolio.
Investors consider the following metrics when making investment decisions:
1. Time horizon
The time horizon is important, as most downside risk management strategies are more appropriate for investors with a long-term investment horizon.
2. Risk tolerance
The investor risk tolerance is vital to measure the amount of risk an investor is prepared to assume on given investments. It will assist in determining the downside protection strategy appropriate for an investor.
3. Cost
Downside risk management strategies can be costly to implement depending on the type of strategy. Hence, understanding an investor’s willingness to pay for downside risk protection is very important.
Protection Strategies
1. Diversification
Diversification is one of the traditional and simplest ways of managing downside risk exposure. Instead of just maintaining traditional assets, such as equity and fixed income instruments, the addition of alternative assets that are less correlated to market drivers – such as inflation, liquidity, and interest rates – assists in the reduction of downside risk.
Hence, the addition of alternative investment assets dilutes the sensitivity to the market correlation of traditional assets limiting the overall downside risk of the portfolio.
2. Tactical asset allocation
Tactical asset allocation is a market timing strategy that allocates assets depending on changing economic and market conditions. It involves allocating portfolio assets to different asset classes and can involve decreasing exposure to volatile assets or asset classes during a market downturn or target specific assets that are not correlated with the market, among other TAA strategies.
Downside risk can be mitigated by targeting specific equities that are less sensitive to market movements. Such equities will show low betas, so during a market downturn, their prices do not follow the market at the same degree as the rest of the equities due to low volatility. A particular skill is needed in stock picking by the fund manager for this strategy to work.
Decreasing exposure to risky assets can be done by literally reducing asset allocations from volatile assets to more stable assets with lower volatility. Volatile assets can be assets like stocks, and less volatile assets can be fixed income instruments, depending on market dynamics.
3. Use of derivative instruments
Derivative instruments can be used to hedge against downside risk and limit the damage caused by market exposures to volatile assets.
4. Other strategies
Volatility cap strategies are rule-based approaches where an investor sets the maximum acceptable volatility and will limit exposures if the limit is breached.
Conclusion
Determining downside risk is crucial in choosing the appropriate hedging strategy. It helps in protecting investor capital and avoiding devastating losses. Therefore, calculating downside risk helps in preparing for the worst-case scenario, such as market shocks, where financial markets move in a downward spiral that is sustained over a longer period, and different asset classes may be caused to correlate.
Downside risk is measured using past data in which a security may not exhibit the same pattern in the future; hence, it should not provide a false sense of security, as the model is not 100% effective but can provide significant hedge and insurance in times of crisis.
Downside risk management strategies should encompass diversification, tactical asset allocation, and the use of derivative instruments. However, care should be made when implementing the strategies to ensure that they are in sync with investor risk tolerance, time horizon, and willingness to pay the related downside protection cost of a particular downside risk protection strategy.
Related Readings
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:
As an expert in financial risk management and investment strategies, I've extensively studied and implemented methodologies to assess and manage downside risk in various financial instruments. The article you provided delves into the concept of downside risk, its calculation methods, and strategies for its management. Let me break down the key concepts discussed in the article:
1. Downside Risk:
Downside risk is the likelihood that an asset or security will decrease in value. It represents the potential loss resulting from a decline in the price of an asset due to changing market conditions. Investors are particularly concerned about downside risk as it focuses on potential losses rather than gains.
2. Calculation of Downside Risk:
The article introduces the use of semi-variance as a method to calculate downside risk. The process involves subtracting the Minimum Acceptable Return (MAR) from each year's actual return, selecting negative returns, squaring them, summing the squared deviations, and then finding the square root of the result. This method provides a quantitative measure of the downside risk.
3. Management of Downside Risk:
The article outlines several strategies for managing downside risk:
a. Diversification:
Diversification is a traditional strategy that involves adding alternative assets less correlated with market drivers. This helps reduce overall portfolio downside risk by diluting sensitivity to market correlation.
b. Tactical Asset Allocation (TAA):
TAA is a market timing strategy that involves adjusting asset allocations based on changing economic and market conditions. It may include reducing exposure to volatile assets during a market downturn.
c. Use of Derivative Instruments:
Derivative instruments, such as options and futures, can be used to hedge against downside risk and limit potential losses caused by market exposures.
d. Volatility Cap Strategies:
These are rule-based approaches where investors set maximum acceptable volatility levels. If breached, exposures are limited to manage downside risk.
4. Considerations for Downside Risk Management:
Investors should consider specific factors before implementing downside risk management strategies:
a. Time Horizon:
Strategies are more suitable for investors with a long-term horizon.
b. Risk Tolerance:
Understanding an investor's risk tolerance helps determine an appropriate downside protection strategy.
c. Cost:
Downside risk management strategies may have associated costs. Investors need to consider their willingness to pay for such protection.
5. Conclusion:
The article concludes by emphasizing the importance of determining downside risk, especially in preparing for worst-case scenarios. It acknowledges the limitations of using past data to measure downside risk and highlights the need for strategies that align with investor characteristics.
In summary, the article provides a comprehensive overview of downside risk, its calculation, and effective strategies for managing it in diverse financial instruments.
