Downside Risk

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.

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

To keep advancing your career, the additional resources below will be useful:

• Model Risk
• Options: Calls and Puts
• Investment Horizon
• Strategic Asset Allocation
• Sortino Ratio
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