Downside Deviation

What Is Downside Deviation?

Downside deviation is a measure of downside risk that spotlights on returns that fall below a base threshold or least acceptable return (MAR). It is utilized in the calculation of the Sortino ratio, a measure of risk-adjusted return. The Sortino ratio resembles the Sharpe ratio, then again, actually it replaces the standard deviation with downside deviation.

Figuring out Downside Deviation

Standard deviation, the most widely utilized measure of investment risk, has a few limitations. For instance, it treats all deviations from the normal — whether positive or negative — as the equivalent. Notwithstanding, investors are generally just irritated by negative amazements. Downside deviation settle this issue by zeroing in exclusively on downside risk. In any case, downside deviation isn't the best way to check losses out. Maximum drawdown (MDD) is one more approach to measuring downside risk.

An extra advantage of downside deviation over standard deviation is that downside deviation can likewise be tailored to the specific objectives. It can change to fit the risk profiles of various investors with different levels of least acceptable return.

The Sortino and Sharpe ratios empower investors to compare investments with various levels of volatility, or on account of the Sortino ratio, downside risk. The two ratios take a gander at excess return, the amount of return over the risk-free rate. Short-term Treasury securities frequently imply the danger free rate.

Assume two investments have a similar expected return, say 10%. Nonetheless, one has a downside deviation of 9%, and different has a downside deviation of 5%. Which one is the better investment? The Sortino ratio says that the subsequent one is better, and it evaluates the difference.

Calculation of Downside Deviation

The initial step of working out the downside deviation is to pick a base acceptable return (MAR). Famous decisions incorporate zero and the risk-free T-bill rate for the year. We'll just involve one here for simplicity.

Besides, we deduct the MAR from every one of the returns.

Downside Deviation Input Data
Year	Return	Return - MAR (1)
2011	-2%	-3%
2012	16%	15%
2013	31%	30%
2014	17%	16%
2015	-11%	-12%
2016	21%	20%
2017	26%	25%
2018	-3%	-4%
2019	38%	37%

The third step is to separate the entirety of the negative numbers, in this case, - 3, - 12, and - 4. Then, we square the negative numbers to acquire 9, 144, and 16. The next step is to sum the squares, which gives us 169 in this case. From that point onward, we partition it by the number of perceptions, 9 in our model, to get around 18.78. At long last, we take the square root of that number to get the downside deviation, which is around 4.33% in this case.

Everything Downside Deviation Can Say to You

Downside deviation provides you with a better thought of how much an investment can lose than standard deviation alone. Standard deviation measures volatility on the upside and the downside, which presents a limited picture. Two investments with similar standard deviations are probably going to have different downside deviations.

Downside deviation can likewise let you know when a "risky" investment with a high standard deviation is reasonable safer than it looks. Think about an investment that pays 40% half the time despite everything pays 20% in less fruitful years. Such an investment would have a lot higher standard deviation than one that just paid 5% consistently. Notwithstanding, scarcely any individuals would agree that that getting compensated 5% consistently was truly safer. Both of these investments would have a downside deviation of zero utilizing 5% as the base acceptable return (MAR). That lets us know that they are both entirely safe investments.

Limitations of Downside Deviation

Downside deviation passes on no data about upside potential, so it gives a deficient picture. In the previous model, we discovered that an investment with a half chance of getting 40% and a half chance of getting 20% had a similar downside deviation as getting 5% without a doubt in the event that we utilize 5% as the base acceptable return (MAR). Notwithstanding, the main investment has a lot higher upside potential. As a matter of fact, it is guaranteed to outperform, the main inquiry is by how much.

Highlights

Downside deviation provides you with a better thought of how much an investment can lose than standard deviation alone.
Downside deviation is a measure of downside risk that spotlights on returns that fall below a base threshold or least acceptable return (MAR).
Downside deviation passes on no data about upside potential, so it gives a fragmented picture.