Downside risk

Risk measures typically quantify the downside risk, whereas the standard deviation (an example of a deviation risk measure) measures both the upside and downside risk. Specifically, downside risk can be measured either with downside beta or by measuring lower semi-deviation. The statistic below-target semi-deviation or simply target semi-deviation (TSV) has become the industry standard.

History

Downside risk was first modeled by Roy (1952), who assumed that an investor's goal was to minimize his/her risk. This mean-semivariance, or downside risk, model is also known as “safety-first” technique, and only looks at the lower standard deviations of expected returns which are the potential losses. This is about the same time Harry Markowitz was developing mean-variance theory. Even Markowitz, himself, stated that "semi-variance is the more plausible measure of risk" than his mean-variance theory. Later in 1970, several focus groups were performed where executives from eight industries were asked about their definition of risk resulting in semi-variance being a better indicator than ordinary variance. Then, through a theoretical analysis of capital market values, Hogan and Warren demonstrated that 'the fundamental structure of the "capital-asset pricing model is retained when standard semideviation is substituted for standard deviation to measure portfolio risk."' This shows that the CAPM can be modified by incorporating downside beta, which measures downside risk, in place of regular beta to correctly reflect what people perceive as risk. Since the early 1980s, when Dr. Frank Sortino developed formal definition of downside risk as a better measure of investment risk than standard deviation, downside risk has become the industry standard for risk management.