What Is Downside Risk?

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DEFINITION
Downside risk is the risk of loss in an investment or portfolio. Calculation of downside risk varies depending on the type of investment and type of investor. For example, large Wall Street institutions betting on derivatives over a week-long period won’t calculate downside risk the same way as value-investing fund managers who hope to own a stock for a decade or more.

Downside risk is the risk of loss in an investment or portfolio. Calculation of downside risk varies depending on the type of investment and type of investor. For example, large Wall Street institutions betting on derivatives over a week-long period won’t calculate downside risk the same way as value-investing fund managers who hope to own a stock for a decade or more. 

Definition and Examples of Downside Risk

Downside risk is the risk that an investment could lose value. This could mean a permanent loss of capital or simply the risk of a downturn over the next few weeks—it depends on the investor. 

Well-known value investor Charlie Munger famously noted that, to him, downside risk is either the permanent loss of capital or the risk of inadequate return. Munger and most other value investors take an extraordinarily long-term view of investments.

For traders and large institutions that make shorter-term bets, downside risk can be calculated using a metric such as value-at-risk (VaR) which estimates what probability of downside is over a certain period of time. Institutions may use this metric to determine what their exposure is to certain investment and traders can use it to determine position sizes.   

How Downside Risk Works

How downside risk works is a matter of understanding the main types of calculations that investors use to determine downside risks: permanent loss of capital, risk of inadequate return, and value-at-risk (VAR). Once the investor uses their preferred risk measure, they make a decisions about whether or not the asset is worth investing in.

Permanent Loss of Capital

Credit analysts and financial analysts can put hours of work into determining whether a company has a high bankruptcy risk (permanent loss of capital), but there is also an easy method for individual investors to use. It’s called the Altman-Z Score

Edward Altman first proposed the method for gauging bankruptcy risk in 1968 and it has been widely used since then. You can calculate Z-score using the following formula:

Z = 0.012A + 0.014B + 0.033C + 0.006D + 0.999E

A = Working Capital/Total Assets

B = Retained Earnings/Total Assets

C = EBITDA/Total Assets

D = Market Value of Equity/Total Liabilities

E = Sales/Total Assets 

Each of the variables in the formula was chosen based on Altman’s research into bankrupt firms. The formula allows analysts to quickly consider a company’s liquidity, prior reinvestment, productivity, market position, and asset turnover. 

Altman suggests that distressed companies with a Z-Score below 1.81 have a considerable risk of going bankrupt and businesses with a Z-Score over 2.99 will likely not go bankrupt.

You can find all the information you need to calculate Z-score in a company’s 10-Q filings and on brokerage platforms.

Risk of Inadequate Return

Risk of inadequate return is another way of saying “opportunity cost,” the value of what the investor could’ve earned by choosing a better investment. For Buffett, putting millions or even billions of dollars into an investment for it to only return 5% per year is a problem. 

Investors want to know they maximized their return as compared to other investment options they could’ve invested in. One way value investors attempt to minimize opportunity cost is with a margin of safety. The margin of safety is the difference between an investment's intrinsic value and current market value. 

Let’s say an investment has an intrinsic value of $100 and a market price of $80. The margin of safety would be 20% (1- (80/100)). The higher the margin of safety on an investment, the higher the potential return as it appreciates back to its intrinsic value. 

Value-at-Risk

Value-at-risk (VAR) is a way of expressing the maximum loss in an investment over a time horizon. VAR is typically presented in a statement like this: “There is a 1% one-week VAR of 5%.” In other words, over the next week, there is a 1% chance that the investment will lose 5% of its value. 

VAR is most often used for shorter holding periods like a day, week, or two weeks. To calculate VAR, the analyst chooses the time horizon and confidence interval and then does statistical analysis to find value at risk. In the statement example above, the value was 5% of the investment, the value can also be stated as an absolute dollar amount. 

There are several different statistical models used to calculate VAR, but, for the most part, they each rely on using past returns for calculation. Because of this, the reliability of VAR suffers the further out the time horizon goes. 

Is Downside Risk Worth It?

There is some evidence that the higher the downside risk the higher the potential return on investment and that makes sense. If you’re able to identify an investment with a Z-Score below 1.81 that doesn’t go bankrupt you might make a lot of money because the stock price will be heavily depressed but eventually rise.

That said, the most important part of downside risk for the individual investor is managing it. Investors can manage downside risk in their core portfolio by diversifying into other assets that are uncorrelated to the general market or tend to be lower risk. Some widely recommended assets are high-quality bonds, gold, and reinsurance stocks.

Key Takeaways

  • Downside risk is the risk of loss in an investment.
  • Calculation of downside risk varies depending on the user. Long-term investors focus on permanent loss of capital and opportunity cost, and traders or institutions focused on exposure focus on VAR. 
  • Individual investors can manage downside risk with diversification. 

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