What is a Downside Risk?
How Does a Downside Risk Work?
Let's assume an investor owns 1,000 shares of Company XYZ and she's paid $100,000 to own that stock. Because the stock price could theoretically fall to zero under the right economic conditions, the downside risk of the investment is 100% or $100,000.
Hedging is an attempt to limit the downside risk of an investment. In our example, the investor might purchase a put option on the shares, meaning that she has the right to force the counterparty to buy the Company XYZ shares for a certain price. That way, the investor can obtain at least a minimum amount for the shares and thus limit her downside risk.
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Why Does a Downside Risk Matter?
Evaluating downside risk helps investors avoid focusing solely on performance statistics. It also helps them plan for the worst and navigate difficult markets with less emotion or fear. Several financial studies show that the higher a stock's downside risk is, the more it should be expected to return.
Some studies have also found that stocks with high past returns have more downside risk than stocks with low past returns. That is, they're more likely to tank when the market falters.