Downside Risk: Definition, Example, and How To Calculate (2024)

What Is Downside Risk?

Downside risk is an estimation of a security's potential loss in value if market conditions precipitate a decline in that security's price. Depending on the measure used, downside risk explains a worst-case scenario for an investment and indicates how much the investor stands to lose. Downside risk measures are considered one-sided tests since the potential for profit is not considered.

Key Takeaways

  • Downside risk is an estimation of a security's potential loss in value if market conditions precipitate a decline in that security's price.
  • Downside risk is a general term for the risk of a loss in an investment, as opposed to the symmetrical likelihood of a loss or gain.
  • Some investments have an infinite amount of downside risk, while others have limited downside risk.
  • Examples of downside risk calculations include semi-deviation, value-at-risk (VaR), and Roy's Safety First ratio.

Understanding 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 bounded by zero. The investor can lose their entire investment, but not more. A short position in a stock, however, as accomplished through a short sale, entails unlimited downside risk since the price of the security could continue rising indefinitely.

Similarly, being long anoption—either a call or a put—has a downside risk limited to the price of the option's premium, while a “naked”short call option position has an unlimited potential downside risk because there is theoretically no limit to how far a stock can climb.

A naked call option is considered the riskiest option strategy, since the seller of the option doesn’t own the security, and would have to purchase it in the open market to fulfill the contract. As an example, if you sell a call option with a strike price of $1 and the stock climbs to $1,000 by contract expiration, you would have to purchase the stock at $1,000 and sell it at $1; not a good return on investment

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 possible rewards. Downside risk is in contrast to upside potential, which is the likelihood that a security's value will increase.

Example of Downside Risk: Semi-Deviation

With investments and portfolios, a very common downside risk measure is downside deviation, which is also known as semi-deviation. This measurement 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.

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

σ=i=1N(xiμ)2Nwhere:x=Datapointorobservationμ=Dataset’saverageN=Numberofdatapoints\begin{aligned} &\sigma = \sqrt{ \frac{ \sum_{i=1}^{N} (x_i - \mu)^2 }{ N } } \\ &\textbf{where:} \\ &x = \text{Data point or observation} \\ &\mu = \text{Data set's average} \\ &N = \text{Number of data points} \\ \end{aligned}σ=Ni=1N(xiμ)2where:x=Datapointorobservationμ=Dataset’saverageN=Numberofdatapoints

The formula for downside deviation uses this same formula, but instead of using the average, it uses some return threshold—the risk-free rate is often used.

Assume the following 10 annual returns for an investment: 10%, 6%, -12%, 1%, -8%, -3%, 8%, 7%, -9%, -7%. 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% and the downside deviation of this data set is 3.27%. This shows that about 40% of the total volatility is coming from negative returns and 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.

Other Measures of Downside Risk

The SFRatio

Other downside risk measurements are sometimes employed by investors and analysts as well. One of these is known as Roy's Safety-First Criterion (SFRatio), which allows portfolios to be evaluated based on the probability that their returns will fall below a minimum desired threshold. Here, the optimal portfolio will be the one that minimizes the probability that the portfolio's return will fall below a threshold level.

Investors can use the SFRatio to choose the investment that is most likely to achieve a required minimum return.


At an enterprise level, the most common downside risk measure is probably Value-at-Risk (VaR).VaR estimates how much a company and its portfolio of investments might lose with a given probability, given typical market conditions, during a set time period such as a day, week,or year.

VaR is regularly employed by analysts and firms, as well as regulators in the financial industry, to estimate the total amount of assets needed to cover potential losses predicted at a certain probability—say something is likely to occur 5% of the time. For a given portfolio, time horizon, and established probability p, the p-VaR can be described as the maximum estimated loss during the period if we exclude worse outcomes whose probability is less than p.

Downside Risk: Definition, Example, and How To Calculate (2024)


Downside Risk: Definition, Example, and How To Calculate? ›

Downside risk is an estimation of a security's potential loss in value if market conditions precipitate a decline in that security's price. Depending on the measure used, downside risk explains a worst-case scenario for an investment and indicates how much the investor stands to lose.

What is the meaning of risk to the downside? ›

E.g. "Risk to the downside" means risk if market moves down, "downside put" means OTM put, etc.

Which potential outcome is the best example of a downside risk? ›

Which potential outcome is the best example of a downside risk? A downside risk predicts a negative effect on attaining objectives. In a situation in which an org. accelerates its work schedule on a project, a downside risk would be errors caused by employees working more hours & producing deliverables faster.

Which of the following is a measure of downside risk? ›

Specifically, downside risk can be measured either with downside beta or by measuring lower semi-deviation. The statistic below-target semi-deviation or simply target semi-deviation (TSV) has become the industry standard.

What is the formula for calculating risk? ›

Risk is the combination of the probability of an event and its consequence. In general, this can be explained as: Risk = Likelihood × Impact. In particular, IT risk is the business risk associated with the use, ownership, operation, involvement, influence and adoption of IT within an enterprise.

How do you calculate downside risk deviation? ›

How to calculate downside deviation: An example. Downside deviation measures to what extent an investment falls short of your minimum acceptable return by calculating the negative differences from the MAR, squaring the sums, and dividing by the number of periods, and taking the square root.

What is downside explanation? ›

Meaning of downside in English. a disadvantage of a situation: The downside of living here, of course, is that it is expensive. Unemployment, inflation, and greater inequality are often the downside of a market economy.

How do you use downside risk in a sentence? ›

Analysts say the stock has little downside risk at its current price.

What is downside risk in project management? ›

A common threat (or "downside risk") in a software development project is for a task to overrun its schedule. Typical response strategies include the allocation of additional resources or the de-prioritization of other tasks. Conversely, an "upside risk" might be that the task takes less time than planned.

What is a downside scenario? ›

Downside Case – Think of this scenario as the most severe and conservative case. A Downside Case could reflect when revenue growth stalls, business units fail to cut costs, or a recession hits.

What is a potential downside? ›

A downside is the potential negative movement, while downside risk looks to quantify that potential move. For the most part, the higher the downside potential the greater the upside potential. This goes back to the idea of the higher the risk, the higher the reward. An upside is a positive move in an asset price.

What are downside risk protection strategies? ›

Downside protection strategies involve adjusting a portfolio's market exposure to limit the impact of potential losses from market downturns. These strategies can be applied to different types of asset market exposures, but are most commonly focused on equity, followed by fixed income.

How do you calculate downside capture? ›

Downside capture ratios are calculated by taking the fund's monthly return during the periods of negative benchmark performance and dividing it by the benchmark return.

What does risk skewed to the downside mean? ›

Positive skewness means that upside potential is greater than downside risk, and negative skewness means that downside risk is greater than upside potential.

What is the downside ratio formula? ›

The ratio is calculated by dividing the Scheme's returns by the returns of the index during the down-market and multiplying that factor by 100. A Fund Manager who has a capture ratio less than 100 has outperformed the index during the down-market by falling less than the index.

How do you calculate downside ratio? ›

The Downside Capture Ratio is calculated by taking the fund's compounded monthly returns during months when the index has had a negative return and dividing it by the index's compounded monthly returns.

How do you calculate downside risk for Sortino ratio? ›

The calculation for the Sortino ratio is as follows: S = (Mean portfolio return – MAR)/ Downside deviation. Because the Sharpe ratio defines risk as standard deviation, it falls prey to the same shortcomings as stan- dard deviation.

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