No one invests with an eye to losing money, but estimating the downside risk of any investment is—or at least ought to be—part of the process when selecting securities to put in your portfolio. If market conditions change in a certain way, what is likely to be the worst-case scenario when it comes to this stock, this fund, this index….?
Hindsight, as they say, has 20-20 vision. But downside risk measures attempt to offer a better vision of future results. By definition, these measures are one-sided, because they calculate the likelihood of loss, disregarding the potential for gain. Whether it’s a banker deciding whether or not to approve a loan to a business or a money manager deciding which securities to include in a portfolio, risk management is crucial, because, as Will Kenton writes in Investopedia, “wrong choices can result in severe consequences for companies, individuals, and the economy.”
In general, investment risk is defined as a deviation from an expected outcome (or, in the case of downside risk, a deviation from the desired outcome).
There are two general components included in downside risk measurements: the time horizon and the confidence interval, Wall Street Mojo explains. First, it’s important to analyze the degree of downside risk based on a particular (and reasonable) anticipated holding period for that investment—Do you anticipate it being half a year? A year? Several years? The second parameter is the confidence interval, another way of expressing the comfort level of the investor (or the institution managing the risk).
While downside risk deals with unexpected events that have the potential to negatively impact your investment, those unexpected risks can take several different forms. Wall Street Mojo names four main categories of downside risk:
Opportunity risk—Whenever you commit resources to one investment, you are “losing” the opportunity to invest those dollars in other things (which might have turned out to have been better choices!)
Uncertainty risk—Unexpected events can interfere with your investment enjoying its hoped-for growth. These might include everything from natural calamities, such as snowstorms or floods, to new competitors appearing in the marketplace. The political climate might create uncertainty in certain industries, and unforeseen legal actions might be taken against a company.
Hazard risk—People important to the operation of a company might suffer unexpected illness; chemical accidents or employee injuries might interrupt a company’s ability to operate normally.
Operational risk—Everyday business activities may generate risk through failed procedures or policies, or out of simple human error.
In Dampening the Downside, Reichel and Meschenmosa of Blackrock explain that “the objective of downside protection means avoiding losses that exceed a certain threshold over a given period, with a high degree of probability.” Another way to put it, the authors add, is ”making the portfolio more weather-resistant.” Options strategies can function as “insurance policies,” they add, by allowing investors to “put a firm floor on portfolio valuations.”
“In today’s uncertain environment,” Holly Framsted of Blackrock writes,” there is no shortage of ways investors can lose money.” Strategies that focus on downside risk management can offer investors the comfort to stay invested in the market through all environments, she observes.
Sheaff Brock Managing Director Dave Gilreath agrees—“You might say risk management is even more important than return,” he suggests.
