What are the risks of decline?

Definition and Examples of Downside Risk

How Downside Risk Works

Is Downside Risk Worth It?

Definition and Examples of Downside Risk

Downside risk is the risk of losing an investment or portfolio. The calculation of downside risk varies depending on the type of investment and the investor’s profile. For example, large institutions on Wall Street that bet on derivatives over the course of a week will not calculate downside risk in the same way that value fund managers hopeful in investing in a stock for a decade or more would.

How Downside Risk Works

Understanding how downside risk works involves recognizing the main types of calculations that investors use to determine downside risk: permanent capital loss, inadequate return risk, and value at risk (VAR). Once an investor uses their preferred risk measure, they decide whether the asset is worth investing in or not.

Permanant Capital Loss

Credit analysts and financial analysts may put hours of work into determining if a company faces high risks of bankruptcy (permanent capital loss), but there is also an easy method for individual investors to use. It is called the Altman Z-score.

Inadequate Return Risk

Inadequate return risk is another way to refer to “opportunity cost,” or the value of what an investor could earn by choosing a better investment. For Buffett, putting millions or even billions of dollars into an investment that returns 5% annually is a problem. Investors want to know they are maximizing their returns compared to other investment options they could choose. Value investors try to minimize opportunity cost by using a margin of safety. The margin of safety is the difference between the intrinsic value of an investment and its current market value.

Value at Risk (VAR)

Value at Risk (VAR) is a way of expressing the maximum loss on an investment over a set time period. Value at Risk (VAR) is typically presented in a statement like this: “There is a 1% Value at Risk over one week of 5%.” In other words, over the next week, there is a 1% chance that the investment will lose 5% of its value. Value at Risk (VAR) is primarily used for shorter holding periods such as a day, week, or two weeks.

Is Downside Risk Worth It?

There is some evidence that the higher the downside risk, the greater the potential returns on investment, which makes sense. If you were able to identify an investment with an Altman Z-score below 1.81 that does not go bankrupt, you could make a lot of money because the stock price would be significantly low but will eventually rise. However, the most important element of downside risk for the individual investor is management. Investors can manage their downside risk in their core portfolio by diversifying into other assets that are not correlated with the broader market or tend to be less risky. Some widely recommended assets are high-quality bonds, gold, and reinsurance stocks.

Takeaway

Downside risk is the risk of losing an investment. The calculation of downside risk differs based on the user. Long-term investors focus on permanent capital loss and opportunity cost, while traders or concentrated institutions focus on exposure to value at risk (VAR). Individual investors can manage downside risk through diversification.

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Sources:

– Columbia University Press Blog. “A Dozen Things I’ve Learned From Charlie Munger About Risk, Part 1.”

– Edward I. Altman. “Predicting Financial Distress of Companies: Revisiting the Z-Score and Zeta Models,” Page 2.

–
AccountingTools.com. “Altman Z Score Formula.”

– U.S. Bank. “Four Ways To Manage Downside Risk.”

Source: https://www.thebalancemoney.com/what-is-downside-risk-5219938