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Downside Risk in Practice

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  • Javier Estrada

Abstract

Although investors associate risk with negative outcomes and downside fluctuations, modern portfolio theory does not. For investors, volatility per se is not necessarily bad; volatility below a benchmark is. A stock that magnifies the market's fluctuations is not necessarily bad; one that magnifies the market's downside swings is. Even Harry Mar‐kowitz, the father of modern portfolio theory, viewed downside risk as a better way to assess risk than the “mean‐variance” framework that he ultimately proposed and that has since become the standard. This article highlights the shortcomings of traditional measures of risk (the standard deviation and beta), introduces the concept of downside risk, and discusses two measures of it—the “semideviation” and “downside beta.” It also discusses the use of such measures in asset pricing models to estimate required returns on equity. Data from a few well‐known companies are used to illustrate that the cost of equity based on downside risk can be substantially different from that based on the CAPM. The article concludes with a brief discussion of risk‐adjusted returns and a comparison of the traditional method of calculating such returns with both the Sharpe ratio and its counterpart in a downside risk framework, the Sortino ratio. The appendix demonstrates how to calculate these risk measures in Excel.

Suggested Citation

  • Javier Estrada, 2006. "Downside Risk in Practice," Journal of Applied Corporate Finance, Morgan Stanley, vol. 18(1), pages 117-125, March.
  • Handle: RePEc:bla:jacrfn:v:18:y:2006:i:1:p:117-125
    DOI: 10.1111/j.1745-6622.2006.00080.x
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    Cited by:

    1. Christian Bach & Peter O. Christensen, 2016. "Consumption-based equity valuation," Review of Accounting Studies, Springer, vol. 21(4), pages 1149-1202, December.
    2. Mansourfar, Gholamreza & Mohamad, Shamsher & Hassan, Taufiq, 2010. "The behavior of MENA oil and non-oil producing countries in international portfolio optimization," The Quarterly Review of Economics and Finance, Elsevier, vol. 50(4), pages 415-423, November.
    3. Rui Pedro Brito & Hélder Sebastião & Pedro Godinho, 2016. "Efficient skewness/semivariance portfolios," Journal of Asset Management, Palgrave Macmillan, vol. 17(5), pages 331-346, September.
    4. Longsheng Cheng & Mahboubeh Shadabfar & Arash Sioofy Khoojine, 2023. "A State-of-the-Art Review of Probabilistic Portfolio Management for Future Stock Markets," Mathematics, MDPI, vol. 11(5), pages 1-34, February.
    5. Juliane Proelss & Denis Schweizer, 2014. "Polynomial goal programming and the implicit higher moment preferences of US institutional investors in hedge funds," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 28(1), pages 1-28, February.
    6. Juan Carlos Gutierrez Betancur, 2017. "Robust Estimation of beta and the hedging ratio in Stock Index Futures In the Integrated Latin American Market," Revista Ecos de Economía, Universidad EAFIT, vol. 21(44), pages 37-71, June.
    7. Johannes Hendrik Venter & Pieter Juriaan De Jongh, 2022. "Trading Binary Options Using Expected Profit and Loss Metrics," Risks, MDPI, vol. 10(11), pages 1-21, November.
    8. Daniel Wurstbauer & Wolfgang Schäfers, 2015. "Inflation hedging and protection characteristics of infrastructure and real estate assets," Journal of Property Investment & Finance, Emerald Group Publishing Limited, vol. 33(1), pages 19-44, February.
    9. Hanen Ben Salah & Jan G. Gooijer & Ali Gannoun & Mathieu Ribatet, 2018. "Mean–variance and mean–semivariance portfolio selection: a multivariate nonparametric approach," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 32(4), pages 419-436, November.
    10. James Chong & Drew Fountaine & Monica Her & Michael Phillips, 2009. "EVA: The bubble years, meltdown and beyond," Journal of Asset Management, Palgrave Macmillan, vol. 10(3), pages 181-191, August.
    11. Rui Pedro Brito & Hélder Sebastião & Pedro Godinho, 2015. "Efficient Skewness/Semivariance Portfolios," GEMF Working Papers 2015-05, GEMF, Faculty of Economics, University of Coimbra.
    12. Rakesh Gupta & Junhao Yang & Thadavillil Jithendranathan, 2017. "Diversification into Emerging Markets – An Australian and the US Perspective Using a Time-varying Approach," Australian Economic Papers, Wiley Blackwell, vol. 56(2), pages 134-162, June.
    13. Duc Hong Vo, 2021. "Portfolio Optimization and Diversification in China: Policy Implications for Vietnam and Other Emerging Markets," Emerging Markets Finance and Trade, Taylor & Francis Journals, vol. 57(1), pages 223-238, January.
    14. Chokri Mamoghli & Sami Daboussi, 2010. "Capital Asset Pricing Models and Performance Measures in the Downside Risk Framework," Journal of Emerging Market Finance, Institute for Financial Management and Research, vol. 9(2), pages 95-130, August.
    15. Donovan, Charles & Nuñez, Laura, 2012. "Figuring what’s fair: The cost of equity capital for renewable energy in emerging markets," Energy Policy, Elsevier, vol. 40(C), pages 49-58.
    16. Christian Bach, 2011. "Conservatism in Corporate Valuation," CREATES Research Papers 2011-32, Department of Economics and Business Economics, Aarhus University.
    17. Javier Estrada, 2013. "Are stocks riskier than bonds? Not if you assess risk like Warren Buffett," Journal of Asset Management, Palgrave Macmillan, vol. 14(2), pages 73-78, April.
    18. Puhr, Harald & Müllner, Jakob, 2022. "Foreign to all but fluent in many: The effect of multinationality on shock resilience," Journal of World Business, Elsevier, vol. 57(6).
    19. Zvika Afik, 2015. "Do not put all your eggs in one (time) basket," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 29(3), pages 251-269, August.
    20. Javier Estrada, 2009. "The Gain‐Loss Spread: A New and Intuitive Measure of Risk," Journal of Applied Corporate Finance, Morgan Stanley, vol. 21(4), pages 104-114, September.

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