What Is Downside Deviation?
Downside deviation is a measure of drawback risk that makes a speciality of returns that fall beneath a minimum threshold or minimum suitable return (MAR). It is used throughout the calculation of the Sortino ratio, a measure of risk-adjusted return. The Sortino ratio is rather like the Sharpe ratio, excluding that it replaces the standard deviation with drawback deviation.
Key Takeaways
- Downside deviation is a measure of drawback risk that makes a speciality of returns that fall beneath a minimum threshold or minimum suitable return (MAR).
- Downside deviation gives you a better idea of how so much an investment can lose than standard deviation on my own.
- Downside deviation does now not put throughout any information about upside potential, so it provides an incomplete symbol.
Working out Downside Deviation
Standard deviation, one of the widely used measure of investment risk, has some barriers. As an example, it treats all deviations from the typical—whether or not or now not positive or adverse—because the equivalent. Then again, patrons are normally highest stricken by way of adverse surprises. Downside deviation resolves this issue by way of focusing handiest on drawback risk. Then again, drawback deviation is not the only approach to try losses. Maximum drawdown (MDD) is another way of measuring drawback risk.
An additional advantage of drawback deviation over standard deviation is that drawback deviation may also be tailored to the proper objectives. It would industry to fit the risk profiles of quite a lot of patrons with various levels of minimum suitable return.
The Sortino and Sharpe ratios permit patrons to check investments with different levels of volatility, or in relation to the Sortino ratio, drawback risk. Each and every ratios take a look at further return, the quantity of return above the risk-free rate. Transient-term Treasury securities steadily represent the risk-free rate.
Suppose two investments have the equivalent expected return, say 10%. Then again, one has an issue deviation of 9%, and the other has an issue deviation of 5%. Which one is the better investment? The Sortino ratio says that the second one is highest, and it quantifies the difference.
Calculation of Downside Deviation
The first step of calculating the downside deviation is to choose a minimum suitable return (MAR). Commonplace possible choices include 0 and the risk-free T-bill rate for the 365 days. We will be able to merely use one proper right here for simplicity.
Secondly, we subtract the MAR from each of the returns.
| Downside Deviation Input Wisdom | ||
|---|---|---|
| 365 days | 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 all of the adverse numbers, in this case, -3, -12, and -4. Then, we sq. the adverse numbers to obtain 9, 144, and 16. Your next step is to sum the squares, which supplies us 169 in this case. After that, we divide it by way of the number of observations, 9 in our example, to get about 18.78. In the end, we take the sq. root of that amount to get the downside deviation, which is ready 4.33% in this case.
What Downside Deviation Can Tell You
Downside deviation gives you a better idea of how so much an investment can lose than standard deviation on my own. Standard deviation measures volatility on the upside and the downside, which items a limited symbol. Two investments with the equivalent standard deviations are much more likely to produce other drawback deviations.
Downside deviation can also permit you to know when a “bad” investment with a best standard deviation is possibly extra protected than it sort of feels to be. Believe an investment that may pay 40% phase the time and nevertheless pays 20% in a lot much less a luck years. Such an investment would have a a long way higher standard deviation than one who simply paid 5% once a year. Then again, few folks would say that getting paid 5% once a year was really extra protected. Both a kind of investments would have an issue deviation of 0 using 5% since the minimum suitable return (MAR). That tells us that they are every utterly safe investments.
Obstacles of Downside Deviation
Downside deviation does now not put throughout any information about upside potential, so it provides an incomplete symbol. Throughout the previous example, we found out that an investment with a 50% likelihood of getting 40% and a 50% likelihood of getting 20% had the equivalent drawback deviation as getting 5% it appears that evidently if we use 5% since the minimum suitable return (MAR). Then again, the principle investment has a a long way higher upside potential. In reality, it is confident to outperform, the only question is by way of how so much.
