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Finer Points

What You Need to Know About Downside Risk

02/15/2019

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A term in finance that investors and traders will sometimes use is downside risk, which refers to the potential losses that could come with a given investment.
Investment opportunities are not created equally, and in many cases investments that come with greater potential returns or rewards come with a number of risks – both obvious and underlying – that need to be considered and ideally mitigated prior to investment.
This article will help explain everything you need to know about downside risk, in the interest of helping you invest better and smarter. Read on to learn more.

What Exactly is Downside Risk?

A downside risk is a worst-case scenario projection of how an equity or investment might play in the face of a market change. Downside risks often transcend the share price itself, and should be carefully considered in advance of an investment.

A mistake that a novice investor might make is assuming that an equity or security doesn’t have underlying risks just because the trading price or market cap is currently trending upward.

As stated above, downside risks are often insidious, and newer investors may not know which downside risks to consider in certain investment scenarios.

Downside risk can be measured in a number of quantifiable and qualitative ways. The risks associated with a given investment can differ drastically depending on the nature of the investment itself, as well as the amount of capital placed into a given investment.

Finite Risk vs. Infinite Risk

Downside risks can be further broken down into two categories: finite risks and infinite risks. In the case of many traditional stock investments, the downside risk is finite, as the most an investor can potentially lose is the entirety of their initial investment.

While this downside risk is not insignificant – in fact, it is alarming and should give investors of all types pause – in this scenario, an investor cannot be debited more than the initial investment amount. There is a maximum number that one can sustain in terms of a loss.

To use an example, if a person takes $100 cash into a casino with no way of withdrawing more cash from an ATM, the most that the person can lose or spend at the casino is $100. This risk is finite, as well as quantifiable.

Meanwhile, a downside risk can be considered an infinite or unlimited risk if the investor can sustain losses with no end, or can’t calculate the risk in advance of assuming the risk liability.

Common examples of unlimited risks include short positions, otherwise known as shorts. A short involves selling an asset with the intention to repurchase it later at a lower cost.

While there can be some upside if the investor successfully sells high on a given asset or equity and then reinvests into the asset later at a lower figure, there is no way that an investor can know exactly what an asset will be worth in the future.

Speaking to the stock market specifically, a trader needs to acquire shares upfront to short them – not entirely different from taking on a loan with a compounding interest rate. The account that the shares are withdrawn from is now in a share deficit.

At some point in the future, the investor that sold the shares as a short will purchase back the shares in the same quantity, ideally at a lower cost than he or she originally sold them for. These newly-purchased shares will then be returned to the account that they were borrowed from, and the investor will either see a profit or a loss, depending on the figure that the shares were re-purchased for.

As you can see, an investor could lose an unpredictable amount of money in this scenario, and thus assumes unlimited risk.

If an investor sells 100 shares at $50 per share as a short for $5,000 and is then forced to re-buy 100 shares of the same stock at $75 per share for $7,500, the investor will have lost $2,500 when the shares are returned to the broker or the withdrawn account.

Almost all investments come with a level of risk, with some obviously being riskier than others. But in most cases, investors will want to limit significant downside risks or unlimited risk, as investment becomes much more like gambling as certain risk levels mounts.

Futures Trading

Another trading tactic that comes with varying levels of downside risk is futures contract trading, which relies heavily on speculation and the ability to project the fortunes of a given market.

Investors can trade financial contracts in which the contract holder is obligated to buy or sell an asset at a predetermined time and date. This is called a futures contract.

As one would assume, the downside risk of a future contract can be significant. Not only does trading futures come with downside risk similar to short trading – in which an investor assumes an unlimited amount of risk – but an investor also puts her or himself on a strict deadline.

Futures trading is most often tied to commodities, as traders will exchange futures contracts to speculate on the price changes of assets tied to given equities or companies.

This is speculation bordering on guesswork, and while there can be a lot of upside to futures trading, there is also a corresponding level of downside risk.

Futures trading and short trading is best left to financial experts, as casual and conservative investors are likely better off not assuming the risk and liability commensurate with these types of trading.

Downside Risk and Retirement

Investors in all situations should factor downside risk when analyzing their respective portfolios, but perhaps no more so than those who plan to use parts of their portfolio for income after retirement.

No investor wants to take a loss, but in a situation where an investor plans to use a large portion of their investment returns for day-to-day living, downside risk needs to be mitigated as a much as possible.

While this will likely lead to more-conservative investing – perhaps diversifying a portfolio a bit with more investment in mid-term bonds or mutual funds rather than riskier individual equities – it’s simply unwise for an investor to risk living uncomfortably during retirement by betting on investments with greater potential downside or unlimited downside.

Downside Risk Factors to Consider

Investors do not want to place themselves into situations where they need to chase losses or double-down on bad investments. Screening for potential downside risk factors prior to making an initial investment is one of the strongest ways in which an investor can protect themselves while potential increasing yield.

Some of the downside risk factors that an investor should consider include earning quality, debt to equity, or free cash flow in rules-based indexes.

For example, prior to buying into a given company, smart investors should do their diligence and do a debt-to-equity screen on a given company or equity, even if the share price or market cap looks great.

A company’s debt-to-equity ratio will vary from sector to sector, with equities from sectors such as financials often having higher debt-to-equity due to active loans. This is common within industries such as banking, and not necessarily indicative of poor financial health.

But investors always should check a company’s debt relative to other companies within the same industry to get a feel for a given group’s real financial position. Generally, a higher debt-to-equity ratio indicates that a company or group has financed much of its growth by aggressively taking on loans or debt.

A company with a lot of debt could have greater potential for financial problems down the road, and this is a downside risk that an investor will want to weigh in advance.

An unfortunate reality is that many indexes, in addition to the funds that track them, do not even attempt to manage market risk and downside risk. So, it is incumbent on investors to do their own homework prior to investment.

In short, investors who want more reliable returns should seek strategies that mitigate losses, and in turn perform better over the long run. Considering the factors listed above is one way to potentially guard against losses and ensure better long-term profit.

Manage Downside Risk with the Goal of Maximizing Returns

All but the safest and most-conservative investments – savings accounts that appreciate at tiny percentages, and the like – will come with a degree of risk. These investments will likely not see enough return to justify significant investment capital, and thus most investors will opt for riskier investments with potentially-higher yields.

That said, investors shouldn’t be hasty and assume a ton of unnecessary liability in the form of downside risk. A diverse portfolio with investments of various risk levels, as well as restraint when it comes to riskier moves such as shorting, are great ways to mitigate downside risk while potentially maximizing returns.

Even the most-optimistic investors should carefully research the potential downsides and worst-case scenarios of a given investment, if only to go into an investment with open eyes and if necessary, to hedge against a total loss.

Novice investors would be wise to work with a trusted partner who can help them navigate the unclear waters of investment, and appraise investors of both the potential rewards and downsides of a chosen investment path.

Linden Thomas & Company

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At Linden Thomas, we believe most indexes focus on the wrong things like weighting the index based on the size of a company (market cap).

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