Downside risk is used to evaluate the potential loss in an investment's value during unfavourable market conditions. Unlike traditional risk measures that consider overall volatility, downside risk focuses solely on negative returns. This measure is particularly significant for investors who are more concerned about potential losses than about maximising gains. By emphasising negative movements, downside risk provides a more tailored risk assessment, especially for conservative or risk-averse investors.
The calculation of downside risk involves measuring the deviation of an investment's returns from a predetermined risk-free rate, but only when those returns are below the risk-free rate. This could be, for instance, the return on government bonds. The result is a figure that represents the expected loss in value when the market performs poorly. A higher downside risk indicates a greater potential for loss and vice versa. This metric helps investors understand how much their investments could decrease in value in the worst-case scenarios.
Downside risk is invaluable for portfolio construction and management, particularly for those looking to minimise potential losses. It enables investors to compare securities not just on their return potential but also on their resilience during market downturns. This risk assessment is crucial for building a diversified portfolio that aligns with an investor’s risk tolerance. However, it’s important to remember that downside risk is only one aspect of investment risk. Therefore, it should be considered alongside other factors such as market trends, economic indicators and investment time horizon to make well-informed investment decisions.
This Trustnet Learn article was written with assistance from artificial intelligence (AI). For more information, please visit our AI Statement.