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Downside Risk: What It Is and How to Calculate It
SmartAsset Team
5 min read
An investor researches how to calculate downside risk.
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Downside risk refers to the potential for an investment to decrease in value. Unlike general risk, which considers both upward and downward price movements, downside risk focuses solely on the negative. This more targeted view of potential financial pitfalls can be helpful to investors who are particularly concerned about capital preservation. Common approaches to quantifying downside risk include statistical measures like Value at Risk (VaR) and the Sortino Ratio.
A financial advisor can help you identify investment opportunities and manage risk for your portfolio.
What Is Downside Risk?
Downside risk is an investing concept that refers to the potential loss in value of an investment. It measures the likelihood of an asset declining in price and the extent of that potential decline. Unlike general risk, which considers both upward and downward price movements, downside risk focuses solely on the possibility of loss. This makes it appealing to investors who are particularly concerned about minimizing losses.
While the desired end result of any investment strategy is an increase in value, understanding and managing downside risk is essential for long-term financial success as an investor. By focusing on the potential for loss, investors can develop strategies that not only aim for growth but also safeguard against significant setbacks. This approach is particularly important during volatile market conditions.
For any investor, awareness of downside risk enables them to make more resilient investment choices. Working with a financial advisor can provide valuable insights into downside risk management, helping investors construct a diversified portfolio that balances potential returns with acceptable levels of risk.
How to Measure Downside Risk
An investor measures the downside risk of an investment.
Investors employ some specific financial metrics to help them gain insight into downside risk, allowing them to strategize effectively to limit and avoid losses. Two popular methods for evaluating downside risk are the Sortino Ratio and Value at Risk (VaR).
Sortino Ratio
The Sortino Ratio helps investors measure the additional return they are likely to receive in exchange for taking on downside risk. To calculate this ratio, determine the difference between an investment's average return rate and the risk-free rate. Then divide this figure by the standard deviation of negative returns.
Generally speaking, a higher Sortino Ratio is more desirable for a risk-sensitive investor. A higher number indicates an investment is likely to deliver more return for each additional unit of downside risk that is taken on.
Value at Risk (VaR)
Value at risk (VaR) is another widely used method for assessing downside risk. VaR estimates the maximum loss that an investor might face with a given level of confidence, typically expressed as a percentage. The result is a statistical measure of the potential loss in value of an investment portfolio over a defined period.
For example, a one-day VaR of 5% at a 95% confidence level suggests that there is a 5% chance the portfolio will lose more than the calculated amount in a single day. This method provides investors with a quantifiable measure of risk, helping them understand the potential impact of adverse market movements on their investments.
Risk vs. Downside Risk in Investing
Risk refers to the potential for an investment to deviate from its expected outcome, which can result in either gains or losses. Investors must consider various types of risk, including market risk, credit risk, and interest rate risk, each of which can impact the performance of their investments. By evaluating these risks, investors can better align their portfolios with their financial goals and risk tolerance.
Upside risk is the potential for an investment to perform better than expected. Downside risk specifically focuses on the potential for loss in an investment. General risk, a broader concept, encompasses both positive and negative outcomes.
Downside risk is of particular interest for investors who are risk-averse, which includes many investors nearing retirement age. It helps them understand the worst-case scenarios and prepare accordingly. If downside risk appears excessive, investors can implement strategies such as diversification or hedging to mitigate potential losses and protect their portfolios.
Balancing risk and downside risk is essential for successful investing. While taking on some level of risk is necessary to achieve returns, understanding and managing downside risk helps investors avoid exposing themselves to excessive losses.
Financial advisors often play a key role in helping investors work through these complexities by providing personalized advice and strategies. If you strike the right balance, you could pursue growth opportunities while safeguarding your investments against significant downturns, ultimately achieving a more secure financial future.
Bottom Line
An investor reviews her investment portfolio.
Understanding downside risk is important for investors who are aiming to protect their portfolios from potential losses. This concept refers to the potential loss in value of an investment. Calculating downside risk involves assessing the likelihood and extent of negative returns, which can be achieved through various methods such as value at risk (VaR) and the Sortino Ratio. These tools help investors quantify the risk of loss and make informed decisions about their investments.
Tips for Investors
A financial advisor can help you mitigate risk for your portfolio. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.
If you want to know how much your investments could grow over time, SmartAsset's investment calculator can help you get an estimate.
