# Understanding Downside Risk in Investments: Definition and Calculation

> **Definition**
>
> Downside risk is the potential loss in value of a security due to adverse market conditions, which may represent the worst-case scenario for an investment.

## What Is Downside Risk?

Downside risk is an estimation of a [security's](https://www.investopedia.com/terms/s/security.asp) potential loss in value if market conditions drive its price lower. It reflects a worst-case scenario for an investment and shows how much an investor could lose, focusing solely on losses rather than gains. This article explores key techniques for assessing and mitigating [downside risk](https://www.investopedia.com/terms/u/ulcerindex.asp), such as semi-deviation, value at risk (VaR), and the Sortino ratio, so investors can better manage their portfolios in volatile markets.

### Key Takeaways

*   Downside risk estimates a security's potential loss if market conditions decline, without considering profit potential.
*   Semi-deviation focuses on negative returns, isolating "bad" volatility from standard deviation's overall volatility.
*   Short selling and naked call options carry unlimited downside risk due to potential indefinite price increases.
*   VaR helps estimate potential losses of an investment portfolio during typical market conditions.
*   Downside risk contrasts with upside potential, highlighting the worst-case scenario in security valuation.

## Analyzing Different Types of Downside Risk

Investments can have either limited or unlimited downside risk. Buying a stock has limited downside risk because it can't drop below zero. The investor can lose their entire investment, but not more. Unlimited downside risk can exist with a short position in stock through a [short sale](https://www.investopedia.com/terms/s/shortsale.asp) since the price of the security could continue rising indefinitely.

Similarly, being long an [option](https://www.investopedia.com/terms/o/optionscontract.asp)—either a call or a put—has a downside risk limited to the price of the option's premium, while a “naked” [short call](https://www.investopedia.com/terms/s/short-call.asp) option position has an unlimited potential downside risk because there is no limit to how far a stock can climb. A naked call option is considered the riskiest option strategy, since the seller of the option doesn’t own the security, and would have to purchase it in the open market to fulfill the contract.

Investors, traders, and analysts use a variety of technical and fundamental [metrics](https://www.investopedia.com/terms/m/metrics.asp) to estimate the likelihood that an investment's value will decline, including historical performance and [standard deviation](https://www.investopedia.com/terms/s/standarddeviation.asp) calculations. Investors often [compare the potential risks associated with a particular investment to possible rewards](https://www.investopedia.com/articles/stocks/11/calculating-risk-reward.asp).

> **Important**
>
> Downside risk is in contrast to upside potential, which is the likelihood that a security's value will increase.

## Techniques for Measuring Downside Risk

### Semi-Deviation

With investments and portfolios, a common downside risk measure is downside deviation or [semi-deviation](https://www.investopedia.com/terms/s/semideviation.asp). It is a variation of standard deviation that measures the deviation of only bad [volatility](https://www.investopedia.com/terms/v/volatility.asp) and how large the deviation in losses is.

Since upside deviation is also used in the calculation of standard deviation, investment managers may be penalized for having large swings in profits. Downside deviation addresses this problem by only focusing on [negative returns](https://www.investopedia.com/terms/n/negative-return.asp).

Standard deviation (σ), which measures the dispersion of data from its average, is calculated as follows:

$\begin{aligned} &\sigma = \sqrt{ \frac{ \sum_{i=1}^{N} (x_i - \mu)^2 }{ N } } \\ &\textbf{where:} \\ &x = \text{Data point or observation} \\ &\mu = \text{Data set's average} \\ &N = \text{Number of data points} \\ \end{aligned}$

The formula for downside deviation uses this same formula, but instead of using the average, it uses some return threshold—the [risk-free rate](https://www.investopedia.com/ask/answers/040915/how-riskfree-rate-determined-when-calculating-market-risk-premium.asp) is often used.

Consider these 10 annual returns: 10%, 6%, -12%, 1%, -8%, -3%, 8%, 7%, -9%, -7%. Only returns less than 0% are used for the downside deviation.

This data set has a standard deviation of 7.69% and a downside deviation of 3.27%. This indicates that 40% of volatility is due to negative returns, with 60% from positive ones. Broken out this way, it is clear that most of the volatility of this investment is "good" volatility.

### Understanding Roy's Safety-First Criterion

The SFR Ratio, or [Roy's Safety-First Criterion](https://www.investopedia.com/terms/r/roys-safety-first-criterion.asp) evaluates portfolios based on the probability that their returns will fall below a minimum desired threshold. Here, the [optimal portfolio](https://www.investopedia.com/terms/e/efficientfrontier.asp) will be the one that minimizes the probability that the portfolio's return will fall below a threshold level. Investors can use the SFRatio to choose the investment that is most likely to achieve the required minimum return.

### Exploring Value-at-Risk (VaR)

At an enterprise level, the most common downside risk measure is [Value-at-Risk](https://www.investopedia.com/terms/v/var.asp) (VaR). VaR estimates how much a company and its portfolio of investments might lose with a given probability, given typical market conditions, during a set period such as a day, week, or year.

VaR is regularly employed by analysts and firms, as well as [regulators in the financial industry](https://www.investopedia.com/articles/economics/09/financial-regulatory-body.asp), to estimate the total amount of assets needed to cover potential losses predicted at a certain probability, such as something likely to occur 5% of the time. For a given portfolio, time horizon, and established probability _p_, the _p_\-VaR can be described as the maximum estimated loss during the period if we exclude worse outcomes whose probability is less than _p_.

## How Does Risk Differ From Downside Risk?

Risk is the chance investors take that a security increases or decreases in value. A decline that is unexpected or triggered by a market occurrence, is downside risk. Downside risk represents the worst-case scenario.

## How Does Risk Affect the Return of an Investment?

The level of risk associated with an investment correlates with the level of return the investment may earn. Investors will usually assume more risk if they are rewarded for their risk.

## Does Downside Risk Have Long Term or Short Term Effects?

Downside risk usually causes investments to lose value in the short term. Stock and bond markets may generate positive results over the long term, but market events can cause specific investments or sectors to decline in value in the short term.

## The Bottom Line

Downside risk refers to the potential loss in value a security may face when market or economic conditions drive its price lower, focusing only on negative outcomes rather than gains. Some investments, like stocks, have finite downside risk, while others, such as short positions or certain options, can carry virtually unlimited risk.

Measuring downside risk using tools like semi-deviation, value at risk (VaR), or Roy's Safety First ratio helps investors understand and manage potential losses, enabling more informed and protective investment strategies.

> **Article Sources**
>
> 1.  U.S. Bank. "[4 Ways To Manage Downside Risk](https://www.usbank.com/investing/financial-perspectives/investing-insights/downside-risk-understand-and-manage-it.html)."