Downside Risk

Many common risk measures, such as standard deviation, treat upward and downward movements equally. Downside risk focuses only on the outcomes investors fear: losses and shortfalls.

Downside risk can be measured in several ways. Downside deviation measures the volatility of returns below a target. Maximum drawdown measures the largest fall from peak to trough. Value at Risk estimates a loss that will not be exceeded with a given level of confidence. Expected shortfall estimates the average loss in the worst cases.

For example, two funds with the same overall volatility might differ in downside risk. One might have frequent small gains and rare large losses, while the other has frequent small losses and rare large gains. Most investors would view the first as having greater downside risk.

Focusing on downside risk matches how many people actually experience investing, since losses tend to cause more concern than equivalent gains. It is particularly important for investors who need to withdraw money soon or who cannot afford large losses.