Downside Risk

Downside risk refers to the maximum expected loss caused by changes in market prices of an asset or portfolio in the future. Downside risk reflects investors' tolerance for asset price declines and is also one of the important indicators for measuring investment risk.

Downside risk corresponds to upside risk, which refers to the maximum expected return of an asset or portfolio due to market price changes in the future. Upside risk reflects investors' expectations for asset price increases and is also one of the important indicators for measuring investment returns.

Generally speaking, investors want to pursue high upside risk and low downside risk, but these two risks are often positively correlated, that is, high returns are usually accompanied by high risks, and low returns are usually accompanied by low risks. Therefore, investors need to choose an appropriate asset mix based on their own risk appetite and investment goals to achieve a balance between risk and return.

How to measure downside risk

Common ways to measure downside risk include the following:

Value at Risk (VaR): Value at Risk refers to the maximum expected loss caused by changes in market prices of an asset or investment portfolio within a given confidence interval and holding period. For example, if the VaR of an investment portfolio is 100,000 yuan, the confidence interval is 95%, and the holding period is one month, it means that there is a 95% probability that the investment portfolio will not lose more than 100,000 yuan in the next month. Yuan.

Expected Shortfall (ES): The expected shortfall refers to the average value of these losses if an asset or portfolio loses more than VaR within a given confidence interval and holding period. For example, if the VaR of an investment portfolio is 100,000 yuan, the confidence interval is 95%, and the holding period is one month, it means that there is a 5% probability that the investment portfolio will lose more than 100,000 yuan in the next month. , and the average of these losses exceeding 100,000 yuan is ES.

Downside standard deviation (DD): Downside standard deviation refers to the square root of the average sum of the squares of the negative deviations between the actual return of an asset or portfolio and its expected return. The larger the downside standard deviation, the higher the downside risk for the asset or portfolio.

Sharpe Ratio: The Sharpe Ratio is the ratio between an asset or portfolio's excess return (i.e., return after deducting the risk-free rate) and its overall volatility (i.e., standard deviation). The higher the Sharpe ratio, the higher the return that an asset or investment portfolio can achieve while bearing the same risk.

Sortino Ratio: The Sortino Ratio is the ratio between the excess return of an asset or portfolio and its downside volatility (ie, downside standard deviation). A higher Sortino ratio indicates that an asset or portfolio can earn higher returns while bearing the same downside risk.

How to deal with downside risks

Common strategies for dealing with downside risk include the following:

Diversification: Diversification refers to diversifying funds into assets of different types, regions, industries, and risk levels to reduce the impact of individual asset price fluctuations on the overall investment portfolio, thereby reducing downside risks. The principle of diversified investment is to use the low or negative correlation between different assets to offset part of the risk and achieve the optimization between risk and return.

Hedging: Hedging refers to the use of financial derivatives, such as futures, options, options, swaps, etc., to trade with related or opposite assets held in the spot market to offset or reduce the impact of market price changes. losses, thereby reducing downside risks. The principle of hedging is to use the positive or negative correlation between financial derivatives and assets in the spot market to offset part of the risk and achieve the optimization between risk and cost.

Stop Loss: Stop loss refers to pre-setting an acceptable maximum loss range when making investments. When the market price reaches or exceeds this range, the assets held are sold in a timely manner to avoid further losses. thereby controlling downside risks. The principle of stop loss is to use the difference between the market price and the preset price to limit part of the risk and achieve the optimization between risk and psychology.